Econ Alive! The Power to Choose 9781934534458

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An Economic Way of Thinking How can you think like an economist?

Vocabulary Glossary Vocabulary Cards economics economy positive economics normative economics scarcity tradeoff cost-benefit analysis incentive

Introduction

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Economics impacts your life in both big and small ways. From buying a house to deciding what to eat for lunch, economic principles influence our actions and decisions.

Why are some people and nations wealthy and others poor? This simplesounding question has no easy answer. Over the past two centuries, some of the world’s best thinkers have wrestled with it. Their answers have generated many of the ideas and principles at the heart of the social science we call economics. Among the first to consider this question in depth was a political economist and philosopher named Adam Smith. Born in Scotland, Smith taught at the University of Glasgow and later became Scotland’s commissioner of customs. He is best known for his book An Inquiry into the Nature and Causes of the Wealth of Nations, better known today as The Wealth of Nations. Smith’s book was published in 1776, the same year the Declaration of Independence was written. However, the connection between The Level: A

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Wealth of Nations and the Declaration of Independence does not stop there. In his book, Smith argued that competition is the key to a healthy economy. Nations prosper when buyers and sellers are free to do business in the marketplace without government interference. In the newly independent and liberty-loving United States, Smith’s ideas about competition and free markets took root and grew. In The Wealth of Nations, Smith made many observations about people that still hold true today. For example, Smith observed,

Every man is rich or poor according to the degree in which he can afford to enjoy the necessaries, conveniencies, and amusements of human life. In his 18th-century prose, Smith argued that people want not only the basic necessities of life—food, clothing, and shelter—but also things that entertain them and make life easier, or more convenient. The more of such things they have, the richer they are, at least in economic terms. Smith was not the first to explore everyday economic events, but he developed a way of thinking about those events that had a lasting impact on society and earned him the title “the father of modern economics.” Economists still read The Wealth of Nations to refresh their thinking about fundamental economic principles. This lesson explores some of these principles and how they can help you develop an economic way of thinking. Along the way, the words of Smith and other economists are included to offer you guidance. The more you learn about how to think like an economist, the better you will become at making sound decisions in almost every area of your life.

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Economic Enigma 1: Why does popcorn cost so much at movie theaters? One answer is that theater owners make money by selling either tickets or food. By overcharging for popcorn, they keep ticket prices low to attract people who would otherwise not be able to afford a night out at the movies.

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Economic Enigma 2: Why do prices often end in 99¢? One theory links 99¢ pricing to the invention of cash registers. Pricing goods at 99¢ instead of $1 made it hard to pocket a customer’s dollar bill because the clerk had to ring it up on the register and give the customer 1¢ back.

1. What Is Economics All About? When most people think about economics, they picture numbers, graphs, and equations. Indeed, you will encounter a fair number of graphs and the occasional equation, but that is not necessarily what economics is all about. In their popular book Freakonomics , economist Steven Levitt and journalist Stephen Dubner argue that economics “is about stripping a layer or two from the surface of modern life and seeing what is happening underneath.” This is what Adam Smith did in 1776 and what economists continue to do today. Everyday Mysteries and Economic Enigmas Economists often uncover curious mysteries and enigmas when they strip away a layer from the surface of modern life. These economic enigmas are puzzles or riddles that might be explained through economic analysis. For economist Steven Landsburg, finding and solving such mysteries is what economics is all about:

First, it is about observing the world with genuine curiosity and admitting that it is full of mysteries. Second, it is about trying to solve those mysteries in ways that are consistent 2020 Teachers' Curriculum Institute

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with the general proposition that human behavior is usually designed to serve a purpose. —Steven E. Landsburg, The Armchair Economist: Economics and Everyday Life, 1993 Some of the mysteries that Landsburg refers to are large and abstract. For example, why does an economy grow for a long period of time and then start to shrink? Others deal with smaller, everyday enigmas. For example, Landsburg poses the questions: Why does popcorn sold at the movie theater cost more than at a grocery store? Why are so many products sold for $2.99 rather than $3.00? Not all economists think of their job as investigating economic enigmas. But most would agree that economics has a lot to do with asking questions that reveal what the Freakonomics authors call “the hidden side of everything.” How People Use Limited Resources to Satisfy Unlimited Wants Economics has traditionally been defined as the study of how people— individually and in groups—choose to use their limited resources to satisfy their unlimited wants. This concept of economics goes back at least to the ancient Greek author Xenophon, whose book Oeconomicus described how a household should manage its resources. A resource is anything used to produce an economic good or a service. Resources are limited, or scarce, because they exist in finite amounts. Only so many workers, minerals, machines, and other resources can be used at any given time to produce goods and services. Resources can also have alternative uses. Trees, for example, can be used to construct houses, to make paper, or to burn for fuel. Despite the scarcity of resources, people’s wants are unlimited. While we may have enough goods or services to live, regardless of personal wealth, we will always want more. Economists look at how individuals and societies at large try to satisfy their unlimited wants given their limited resources. This issue is so central to human existence that Alfred Marshall, an influential 19thcentury economist, described economics as “a study of mankind in the ordinary business of life.” The Science of Decision Making Recall Xenophon’s definition of economics. Notice that it also involves studying how people choose to use their resources. When people cannot have everything they want, Level: A

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they must make choices. Some economists argue that economics is primarily about how we make these choices and would therefore define economics as the science of decision making.

Figure 1.1 Economists define economics in different ways, depending on how they view their work.

As a consumer, you are continually making decisions. Should you buy a sandwich or a salad for lunch? If it is a salad, should it be lettuce or spinach? Should you top it with tomatoes, onions, or peppers? What about the dressing? These decisions may seem relatively trivial. But what about larger decisions, such as should you look for a weekend job? Or should you accept a credit card offer you got in the mail? Economists have developed ways of thinking about such choices that can lead to better decision making. What Is and What Should Be: Positive Versus Normative Economics Economists spend a great deal of time describing how and why things are the way they are. But sometimes, economists offer 2020 Teachers' Curriculum Institute

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advice on what should be done to make things better. Consider the following two questions that a school board facing a budget crisis might ask of an economic analyst:

Question 1: What impact will increased enrollment, salary increases, and rising maintenance costs have on next year’s budget? Question 2: What actions should we take now to reduce expenses in order to balance next year’s budget? To answer the first question, the economic analyst would gather facts about the number of new classes needed to cope with rising enrollment, the salaries of school employees, maintenance costs, and other expenses. This type of analysis, which describes how things are, is known as positive economics. To answer the second question, the economic analyst would not only gather facts but also analyze the various choices the school board has for cutting costs. Having laid out the choices and their possible impacts, the analyst would then make a recommendation to the board on where to cut costs. This type of analysis, which focuses on how things ought to be done, is known as normative economics. Many economists are engaged in both positive economics and normative economics. Some economists have taken on the role of policy advisers to government officials or work with businesses. In roles such as these, they go beyond the objective facts to recommend actions based on what they believe to be the best way to achieve the officials’ or company’s desired objectives.

2. What Seven Principles Guide an Economic Way of Thinking? People often think of economics as a limited field of study concerned solely with money, taxes, banking, and trade. These subjects are central to economics. But in studying them, economists have developed principles that apply to much more than just money or business. Examined together, these principles represent an economic way of thinking about the wider world. Try looking for these principles as you take an imaginary summer road trip and attempt to see events along the way as an economist might see them. Principle 1: Scarcity Forces Tradeoffs Level: A

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emphasizes that although our desires for things are unlimited, the resources needed to fulfill our desires are scarce. Because of this scarcity of resources, there will never be enough of everything to satisfy everyone completely, and we will always be forced to make choices as to what we want most. Whenever you choose one thing over another, you are making a tradeoff. You are giving up one thing to gain another that you want even more. The scarcity-forces-tradeoffs principle reminds us that limited resources force people to make choices and face tradeoffs as a result of these choices. Economists have another name for the scarcity-forces-tradeoffs principle: the no-free-lunch principle. This name stems from the observation that every choice—even that of accepting a free lunch— involves tradeoffs. Even if the lunch was free to you, someone had to pay for the meal. And in making that choice, that someone had to go without something else. Looked at in this way, there is no such thing as a “free” lunch. You may not realize it, but you make choices all of the time based on the scarcity-forces-tradeoffs principle. What, for example, should you do next summer? Should you get a job at the mall? The pay might be good, but the work might be boring. Should you find an internship in a career area that interests you? The pay might be low, but the experience could be valuable. Should you volunteer to help build housing for the homeless? Although there is no pay, you might enjoy working with your hands and helping others. Time is scarce, so you can only take one of these jobs. Will it be good pay, valuable work experience, or a sense of satisfaction helping others? The tradeoff for choosing one alternative is giving up the other two. Now consider another option for the summer after you graduate—a crosscountry road trip with your best friend to see a variety of national landmarks. How might the scarcity-forces-tradeoffs principle come into play if you were to buy a used car for the trip? Say you find two cars that fit your budget. One is a large SUV that averages 15 miles per gallon of gasoline, whereas the other is a sedan that gets nearly twice the mileage of the SUV. You cannot buy both. In making a choice, you will have to trade off roominess for good gas mileage or the other way around.

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In purchasing a car for your road trip, you must weigh the tradeoff of buying one car over the other: a more spacious SUV or a sedan with better gas mileage?

Principle 2: Costs Versus Benefits The scarcity-forces-tradeoffs principle forces us to make choices. But how do we decide which alternative to choose? Economists assume that individuals make choices based on the expected costs and benefits. The costs of something are what you spend in money, time, effort, or other sacrifices to get it. The benefits are what you gain from something in terms of money, time, experience, or other improvements in your situation. The costs-versus-benefits principle tells us that people choose something when the benefits of doing so are greater than the costs. To calculate costs and benefits, economists use what is known as a cost-benefit analysis. This analysis might begin with a formal listing of the costs and benefits involved in a choice, as shown in Figure 1.2, or it might be a quick, informal assessment of the costs and benefits. Either way, the analysis should lead to a calculation of which side “outweighs” the other. For example, what are the costs of sleeping an hour longer on a school day? Would you not take a hot shower? Would you lose out on study time? What benefits might you gain? Would you Level: A

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get needed rest or have more energy? A rational choice is one in which the benefits are greater than the costs. Think about how the costs-versus-benefits principle might come into play during your proposed road trip. Each evening after hours of driving, you and your friend face the choice between pitching a tent at an inexpensive campground or paying more for a motel room with a soft bed and a shower. Your decision would depend on your own analysis of the costs and benefits of each arrangement. The choice here is personal. Do the benefits of renting a comfortable motel room outweigh the higher monetary cost? Principle 3: Thinking at the Margin Most everyday choices involve thinking in terms of a little more of this or a little less of that, rather than all or nothing. For example, you may find yourself having to decide whether to study one more hour, buy one more shirt, or eat one more slice of pizza. In economic terms, when we decide to add (or subtract) one more unit to (or from) what we already have, we are thinking “at the margin.” The margin, in this case, is the border or outer edge of something. The thinking-at-the-margin principle tells us that most of the decisions we make each day involve choices about a little more or a little less of something rather than making a wholesale change.

Figure 1.2 Every choice entails costs (something lost) and benefits (something gained). A cost-benefit analysis involves identifying those costs and benefits and weighing them against each other. The best choice is that in which the benefits outweigh the costs.

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Making decisions at the margin involves comparing marginal costs and benefits. The marginal costs is an increase in total costs when you add one unit to something. The marginal benefit is what you gain by adding one more unit to something. Suppose you have just spent two hours studying for an economics test. Should you go to bed or study for another hour? The answer depends on whether you think the marginal benefit of either option—maybe doing a bit better on the test with an extra hour of sleep or feeling more prepared with an extra hour of studying—will exceed the marginal cost—perhaps being less well-rested for the test or feeling less prepared for the test by not studying for another hour. Now think about your road trip. You and your friend have organized your trip around exploring national landmarks in ten cities. But then, your friend suggests adding one more landmark in an additional city. The added landmark is not in your plans, but you would really like to see it too. Here is a decision you must make at the margin. Is the marginal benefit of visiting an eleventh city worth the added costs in time and money? Principle 4: Incentives Matter As we have seen, costs and benefits influence our behavior. That is, they act as an incentive, or something that motivates a person to take a particular course of action. The incentives-matter principle simply says that people respond to incentives in generally predictable ways. When economists want to understand why people do what they do, they start looking for incentives. This principle led Landsburg to write, “Most of economics can be summarized in four words: ‘People respond to incentives.’” Levitt and Dubner would agree:

Incentives are the cornerstone of modern life. And understanding them—or, often, ferreting them out—is the key to solving just about any riddle, from violent crime to sports cheating to online dating. —Steven D. Levitt and Stephen J. Dubner, Freakonomics , 2006 Consider, for example, how people behave when popular devices are released. Why would hundreds of people stand in line on a city sidewalk in the heat of summer or cold of winter for several hours just to purchase the newest cell phone on the market? Certainly they would not behave this way without some sort of powerful incentive.

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Incentives matter in everything we do. For example, examine the Apple store phenomenon created by the release of new products. In 2017, people around the world stood in line for hours outside of Apple stores hoping to purchase the new iPhone 8.

Incentives come in many forms, both positive and negative. Teachers use points and grades as positive incentives to encourage students to complete their assignments and do well on tests. Honor societies and awards are also positive incentives used by schools to motivate students to achieve their highest levels. Governments use negative incentives, such as fines and jail time, to discourage people from breaking laws. You are reminded of this one morning during your road trip when you hit a speed trap. While driving along you suddenly see a police motorcycle with flashing lights behind you. The officer tells you that you were driving 65 miles per hour in a 50-mile-per-hour zone. Worse yet, you were in a construction zone, where fines are doubled. Your decision to ignore the speed limit signs will cost you a hefty $300 fine, as well as the possibility of a point on your license. You decide that is more than enough incentive for you to watch your speed from now on.

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Principle 5: Trade Makes People Better Off Why doesn’t your family make all of its own clothes, build all of its own furniture, grow all of its own food, and produce all of its own medicines? Adam Smith answered that question two centuries ago:

It is the maxim of every prudent master of a family never to attempt to make at home what it will cost him more to make than to buy. The taylor [tailor] does not attempt to make his own shoes, but buys them of the shoemaker. The shoemaker does not attempt to make his own clothes, but employs a taylor. —Adam Smith, The Wealth of Nations, 1776

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Looking at these tools used by tailors and shoemakers reminds us that trade makes people better off. Without trade, we would be spending much of our time sewing our own clothes and making our own footwear.

As Smith understood, no one is equally skilled at doing everything. Nor should we try to be. It makes more sense to concentrate on what we do best and then trade with others for what they do best. The trademakes-people-better-off principle tells us that by focusing on what we do well and then trading with others, we will end up with more and better choices than by trying to do everything for ourselves. Your road trip gives you a firsthand appreciation of this principle when you run into car trouble. One morning, you turn the key and nothing happens. Neither you nor your friend is a mechanic, so you push the car to the nearest gas station and look for help. The mechanic on duty quickly diagnoses the problem as a dead battery. To pay for the battery, you will need to give up visiting two of the cities on your list. You decide to buy the new battery and have the mechanic install it. From this interaction, the mechanic makes money that can be spent on other goods, while you can still visit the other cities on your list. You are disappointed about not seeing those two cities, but everyone involved agrees that trading your money and potential experiences for the new battery makes you all better off than you were that morning. Principle 6: Markets Coordinate Trade When you think of markets, you probably conjure up the image of a supermarket or farmers’ market. Economists, however, take a more expansive view of markets. To them, a market is any arrangement that brings buyers 2020 Teachers' Curriculum Institute

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and sellers together to do business with each other. A market can exist in a single place, like a weekend flea market, or it can exist in cyberspace, such as online shopping.

Markets are remarkably efficient at coordinating the activities of buyers and sellers over vast distances. For example, these coffee beans from El Salvador traveled thousands of miles to reach customers in the United States.

When markets operate freely, or with limited government interference, buyers and sellers can trade with each other until both are satisfied with their sales and purchases. The result is an efficient market that serves everyone’s interests without guidance from a person or an institution. The markets-coordinate-trade principle states that markets usually do better than anyone or anything else at coordinating exchanges between buyers and sellers. Just how markets do all this coordination was not clear to people in Adam Smith’s day. He used the metaphor of an invisible hand guiding human affairs in order to explain this mystery. On your road trip, you feel the invisible hand at work when you visit a supermarket. As you push your cart through the aisles, you see fresh mangoes from Mexico, bananas from Belize, shrimp from Thailand, cheese from France, and salmon from Alaska. You wonder how a grocery store manages to stock its shelves with so many fresh foods from around the world at prices you are willing to pay. Markets coordinate trade with remarkable efficiency in order to provide the best quality products at prices Level: A

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attractive to consumers. Principle 7: Future Consequences Count In general, people are shortsighted, which means that they tend to make decisions by looking only at the immediate costs and benefits. But decisions made today often have longer-term effects that should also be considered. The future-consequences-count principle tells us that decisions made today have consequences not only for today but also in the future. To economist Henry Hazlitt, this principle separates the good economist from the bad. He wrote,

The bad economist sees only what immediately strikes the eye; the good economist also looks beyond. The bad economist sees only the direct consequences of a proposed course; the good economist looks also at the longer and indirect consequences . . . The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy. —Henry Hazlitt, Economics in One Lesson, 1979 Part of thinking like an economist involves trying to imagine all the possible consequences of a decision. But nothing about doing this is easy. Consider a law passed in 1968 in Vermont that banned roadside billboards and other large signs in order to protect the state’s scenic beauty. Since then, businesses have instead built sculptures, including a giant squirrel in red suspenders and a 19-foot-high genie, to attract the attention of passersby. The result of the Vermont law was an example of what economists call the law of unintended consequences . This law says that actions of people and governments always have effects that are not expected, or that are “unintended.” Economists spend much of their time attempting to predict these unintended consequences. Your decision to take a road trip had a variety of consequences—some of which were intended, others not. In the short term, you found out what it was like to be on your own, away from your family. You learned a lot about being independent, handling difficult situations, and making your own way in the world. When you open your insurance bill months later, however, you realize that your trip has had a long-term, unintended consequence. The cost of your insurance has increased because one day last summer you chose to ignore a speed limit sign.

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3. What Tools Do Economists Use? The law of unintended consequences illustrates just how complicated— and frustrating—the work of an economist can be. You might wonder why economists don’t just thrown up their hands and say, “I quit!” But most economists actually like their job and enjoy solving economic enigmas. To do their job properly, economists need ways to examine economic events, simplify them, and figure out how a given economic decision can affect the world. To do this, they need a set of tools. Three of the most effective tools that economists use are the scientific method, graphs, and economic models. The Scientific Method: Question, Hypothesize, and Observe The scientific method involves posing a question, researching the question, developing a hypothesis, conducting studies to collect Level: A

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information, analyzing the information, and then evaluating the hypothesis. You may have applied the scientific method when growing bean plants, examining bacteria under a microscope, or measuring waves in a wave tank. Through such laboratory experiments, you collected data, or factual information, that gave you vital insights into the physical world and its processes. Economists, like other scientists, rely on the scientific method to study how the world works. But they have a big handicap. Usually, they cannot conduct laboratory experiments to make observations or test their theories. For example, an economist might have a theory that raising highway speed limits would improve the economy, in part by enabling the speedier transport of goods from farms and factories to stores. But how might an economist test that theory? It is highly unlikely that government officials would permit an economist to turn the highway system into a huge laboratory.

When economists lack experimental data, they have to be satisfied with whatever data society naturally provides. For this reason, economists have become skilled at analyzing existing and historical data. As it happens, a law that was passed in 1974 resulted in a national maximum speed limit of 55 miles per hour. In 1995, Congress repealed the law, allowing each state to set its own maximum speed limit. Many 2020 Teachers' Curriculum Institute

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states raised their limits, giving economists the chance to analyze how transportation costs varied before and after the speed limit changed.

After the nation allowed states to raise their speed limits above 55 miles per hour, economists had a chance to study how increases in speed affected transportation costs. Examining how people interact with different speed limits provides economists with useful data they would not be able to acquire on their own.

Through such “natural experiments,” economists have learned what types of data are important and have developed ways to examine this data. As economist Steven Levitt noted, “Knowing what to measure and how to measure it makes a complicated world much less so.” Graphs: Two-Dimensional Representations of a ThreeDimensional World Graphs are useful tools for analyzing and displaying data. A graph is a visual representation of the relationship between two given sets of data. One or both sets of data are also known as variables. A variable is a quantity that can vary, or change. Economists use two-dimensional graphs to simplify the complex, Level: A

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threedimensional world in which we live. However, because it is a simplification, a graph may not yield a complete picture of how two sets of information are related. Nonetheless, it gives economists an important tool for examining the relationship.

Figure 1.3 One of an economist’s most important tools is the graph. Graphs are used to show how two variables—in this case, education and income— relate to one another. Notice how the data in the table are plotted on a graph to represent this relationship in a visual way.

Consider how economists might analyze the relationship between the level of education an individual has and that individual’s annual income. They would begin by gathering information. The table in Figure 1.3 shows data for the year 2017. The two variables in this table are level of education and income. Each dollar figure in the table represents the average annual income of every person at that education level who had an income in 2017. The same data can also be plotted on a coordinate system, like the 2020 Teachers' Curriculum Institute

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graphs shown with the table. A coordinate system consists of two perpendicular lines that can be used to locate a point in space. Each of the two perpendicular lines is called an axis. The horizontal line is the x-axis, and the vertical line is the y-axis. Once the data in the table are plotted as a set of points in the coordinate system, the points can be joined to form a curve. A curve is any line representing data points plotted on a graph. As you can see in Graph 3 in Figure 1.3, a curve doesn’t have to be curved. In fact, straight lines on a graph are also called curves. The shape of this curve tells us that, on average, the higher level of education people have, the higher their incomes will be. As useful as graphs are at representing relationships, they have their limitations. The graphs in Figure 1.3 do not, for example, shed light on factors other than education that might have affected income in 2017. Suppose an unusually harsh winter had slowed construction projects and delayed spring planting across the country that year. The impact of such a slowdown would have fallen most heavily on construction workers and farmworkers, many of whom lack college degrees. As a result, their 2017 incomes would have been lower than usual for reasons quite unrelated to education. Economic Models: Simplified Representations of Reality Economists use models to help them understand how the world works. An economic model is a simplified representation of reality that often allows economists to focus on the effects of one change at a time. Models can also help economists structure their thinking. A model can take the form of an equation, a computer program, or a diagram, or it can consist mainly of a written description. One widely accepted descriptive model is called homo economicus . This is Latin for “economic man,” although it applies to all human beings. It is also called the rational-behavior model. This model is a tool for understanding the mystery of human behavior. It theorizes that people behave in ways that are rational, or based on reason. That is, people make decisions that they think will fulfill their wants and needs to the greatest extent possible. They therefore behave in ways that serve their own interests, without taking into account the well-being of others.

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This cartoon shows a wealthy person who has taken control of many industries throughout society. His behavior is driven by the rationalbehavior model, as each thing he owns fulfills his need for more power or money.

The rational-behavior model, with its focus on self-interest, arose after the time of Adam Smith. But the pursuit of self-interest plays a key role in Smith’s descriptions of the free market. As if guided by an “invisible hand,” self-interested market activity ends up benefiting all of society. This is the point Smith made in describing the typical businessperson:

It is his own advantage, indeed, and not that of the society, which he has in view . . . He intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. —Adam Smith, The Wealth of Nations, 1776 Models are an approximation of how people, in general, act. As such, models cannot accurately predict all behavior all of the time. Economists who construct models must make assumptions. Consider the model just described, which assumes that people always act for their own benefit. Economists know that the rational-behavior model does not deal with social values, such as charity, that might curb selfinterest. Nor does it deal with decisions based on limited or false information. Faced with these missing factors, the economist says, “Ceteris 2020 Teachers' Curriculum Institute

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paribus,” which is Latin for “other things being equal” or “other relevant factors remaining unchanged.” This is the economist’s way of saying, “Let’s focus on understanding what happens if we change one aspect of the mystery and keep all other aspects the same.” This then leads the economist to think, “Maybe if I can understand this one aspect, I can begin to understand the larger mystery.” Economist Alfred Marshall describes ceteris parabis this way,

The more the issue is thus narrowed, the more exactly can it be handled. . . exact discussions can be made less abstract, realistic discussions can be made less inexact than was possible at an earlier stage. Thus, economic models aid in examining effects, one change at a time, and in making predictions about the consequences of that change. Good economic models are useful for both explaining and predicting how the economy operates. The rational-behavior model works fairly well at predicting how people generally react to incentives or how they use cost-benefit analyses to make decisions. By and large, we do these things without even consciously thinking about them. When this happens, we are behaving as this economic model would predict. According to this model, humans make decisions based on their own best interests. So, is thinking like an economist in your best interest? It certainly is if it helps you make better decisions. Throughout this program, you will use these principles and tools to become a more informed consumer and citizen, and to develop you own understanding of the world.

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Economists create models to try to understand how the world works. The theory behind the rational-behavior model is that people make decisions based on their own self-interest. But can this model explain why these students chose to volunteer at a local garden? Not really. Despite its limits, the model helps economists predict and explain human behavior.

Lesson Summary Economics is both a social science and a way of thinking about how the world works. It can help us unravel everyday mysteries and make better decisions about matters both large and small. What is economics all about? Economics is the study of how individuals and societies use their limited resources to satisfy their unlimited wants. Positive economics looks at the way things are and why. Normative economics looks at the way things ought to be. In examining how people make decisions about production and consumption, economists attempt to dig beneath the surface of everyday life. What principles guide an economic way of thinking? 2020 Teachers' Curriculum Institute

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Economists have identified several principles that can help us understand how people make choices and how their decisions affect others. They include the following: scarcity forces tradeoffs benefits should outweigh costs decisions are often made at the margin incentives matter trade makes people better off markets coordinate trade better than anything or anyone else decisions made today have consequences in the futuree What tools do economists use? Economists use the scientific method to analyze economic events and predict outcomes. They use graphs to analyze the relationship between two sets of data. They also use economic models to better understand how the world works. An economic model can take various forms, such as a diagram, an equation, or a description.

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Economic Decision Making Why can’t you always get what you want?

Vocabulary Glossary Vocabulary Cards goods services factors of production entrepreneurship capital productivity opportunity cost production possibilities frontier (PPF)

Introduction

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Before they sold out stadiums, the Rolling Stones had to make decisions about which career to pursue.

Since the 1960s, the Rolling Stones have been considered one of the most iconic musical acts in the world. Many of their songs still remain popular, several decades after they were released. Rolling Stone magazine even listed one of the band’s songs “You Can’t Always Get What You Want” as one of the greatest songs of all time. As simple as it sounds, the title explains why everyone has to make choices—even Mick Jagger, Keith Richards, and the other members of the self-styled “Greatest Rock and Roll Band in the World.” What you may not know about Michael Philip Jagger is that he was once a student of economics. Born into a middle-class family in Dartford, England, Jagger was raised to be a teacher like his father, earning high enough marks in school to win a scholarship to the prestigious London School of Economics. Jagger was studying accounting and finance in 1961 when a chance meeting with Keith Richards, a boyhood friend, changed his life. “So I get on the train to London one morning, and there’s Jagger and under his arm he has four or five albums,” Richards later recalled. “He’s got Chuck Berry and Little Walter, Muddy Waters.” Level: A

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Jagger invited Richards to join a few of his friends who played music together for fun. Once Richards did so, life began to change. “You could feel something holding the band together,” a friend observed. “Keith sounded great.” This worried Jagger’s mother, who had noticed that after teaming up with Richards, her son had begun to think of music as more than just a hobby. A year after this meeting, a new R&B band billing itself as the Rolling Stones began to appear in London clubs. Then, in 1963, the Stones released their first record. Jagger now faced a difficult choice: finish his degree or drop out of college to pursue a career in music. He later said of his decision,

It was very, very difficult because my parents obviously didn’t want me to do it. My father was furious with me, absolutely furious. I’m sure he wouldn’t have been so mad if I’d have volunteered to join the army. Anything but this. He couldn’t believe it. I agree with him: It wasn’t a viable career opportunity. Despite his parents’ misgivings, Jagger chose music—and the rest, as they say, is history. This lesson is about the choices and decisions we all face in our lives. It explores why, as the song says, we can’t always get what we want. And, it looks at how we can use the economic way of thinking to decide what we want most and what we are willing to give up to get it.

1. Why Is What We Want Scarce? Every time we go shopping, most of us come up against the hard truth that we can’t always get what we want. But why is this so? Why do any of us have to choose at all? Our Wants Always Exceed Our Resources The simple answer to that question is that our wants—our desire for things that meet our needs or make us happy—are unlimited, while our means of fulfilling those desires are not. Some of our wants are necessary for survival. Each of us, for example, needs food, water, and shelter to survive from day to day. However, beyond those basic necessities, what we desire to have, use, or experience is limited only by our imaginations. Although our wants may be unlimited, our ability to satisfy them is not. We have only finite amounts of resources at our disposal. Time, for 2020 Teachers' Curriculum Institute

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example, is a limited resource. Whether rich or poor, a person has only 24 hours available each day. Money is also limited. Even the very rich can’t afford an endless supply of everything. They, like the rest of us, experience scarcity, a situation in which the supply of something is not sufficient to satisfy their wants. With Resources Limited, Scarcity Is Everywhere It is hard for most people to see scarcity the way economists do. You may shop in stores that are overflowing with goods, or physical objects produced for sale. You might look around your classroom and see that nearly everyone has paper and pencils. Many, if not all, of your classmates have cell phones. How can these goods be scarce if everyone seems to have them? Similarly, most of us have access to a multitude of services, or activities done for us by others. Teachers, doctors, hair stylists, bus drivers, plumbers, nurses, and police officers all provide services we take for granted. Some are even offered to us without charge. So, how can economists see these services as scarce?

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It may seem like cell phones are an unlimited good because almost everyone has one and there are constantly new cell phone releases. However, the materials and labor needed to build them are scarce, which makes phones scarce as well.

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During Atlantic hurricane season, many stores sell out of bottled water as people stock up to prepare for an incoming storm. During this time, scarcity is a visible and inescapable fact of life.

And yet, goods and services are scarce. They are scarce because the resources needed to produce them—land, labor, materials, and machines—are scarce. Should you doubt that this is true, try asking someone who owns one of these resources to turn it over for free. The answer will almost surely be no. Scarcity would exist even if everyone in the world suddenly became extremely wealthy. Suppose every new multimillionaire wanted to build an elegant mansion to live in. Could they all do so? Probably not. While one essential resource for such a project (money) is now less scarce, other essential resources (such as land, lumber, concrete, glass, skilled workers, and time) are still just as scarce. Shortages Are Temporary, While Scarcity Is Forever While scarcity may seem like an abstract idea, most of us have experienced a shortage. A shortage is a lack of something that is desired, a condition that occurs when there is less of a good or service available than people want at the current price. When a venue runs out of concert tickets while the band is performing in that city, the result is a shortage. Shortages occur for many reasons. A fashion fad can cause a shortage by suddenly increasing the number of people who want to buy the trendy item. The shortage lasts until either enough items are produced for everyone who wants them or the fad ends. Level: A

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Wars and natural disasters can cause shortages by disrupting the production or movement of goods. Each year before the Atlantic hurricane season, for example, people prepare for it by buying bottled water. However, because so many people are trying to buy water at the same time, many stores often completely sell out. Some people have to rely on donations to get the water they need. Shortages are usually a temporary condition, however. A shortage ends once production is resumed or new sources of supply are found. In contrast, scarcity is forever. No matter how well people use their limited resources, there will never be enough.

2. How Do We Satisfy Economic Wants Take a quick break from reading and let your eyes wander around wherever you happen to be just now. What do you see? Walls, windows, furniture, books, desks, paper, pens, pencils . . . the list could likely go on and on. None of these goods magically appeared at this moment for your comfort and convenience. All of them were produced to satisfy somebody’s wants. The question is, how is this done? Inputs, Outputs, and the Production Equation Economists answer this question by looking at the inputs and outputs of the production process. Inputs are the scarce resources that go into the production process. Economists call these productive resources the factors of production and divide them into three basic categories: land, labor, and capital. Outputs are the goods and services produced using these resources. Economists use the production equation to represent the process of combining resources (inputs) to produce goods and services (outputs). In its simplest form, the production equation looks like this: land + labor + capital = goods and services Some economists consider entrepreneurship—the willingness to take the risks involved in starting a business—to be a fourth factor of production. Entrepreneurs are people who assemble the other inputs to create new goods and services. Land Resources: The “Gifts of Nature” As seen by economists, land is far more than real estate. It means all of the natural resources that are used to produce goods and services. These resources include 2020 Teachers' Curriculum Institute

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familiar natural resources as air, soil, minerals, water, forests, plants, animals, birds, and fish. Others are less obvious, such as solar energy, wind, geothermal energy, and the electromagnetic spectrum used to transmit communication signals.

The company that owns this oil field is harvesting both nonrenewable and renewable energy resources. The oil being pumped out of the ground cannot be replaced. In contrast, the wind driving the turbines that generate electricity will never be used up. Level: A

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Natural resources vary in their abundance and availability. A few, such as sunlight and wind, are perpetual resources that are both widely available and in no danger of being used up. Others, including forests, fresh water, and fish, are renewable resources that, with careful planning, can be replenished as they are used. A few resources, mostly metals, can be recycled for use again and again. Still others, especially fossil fuels such as oil, coal, and natural gas, are nonrenewable resources. Once they are used, they are gone forever. The value of natural resources depends on someone knowing how to incorporate them into the production process. Vast pools of oil have lain under the surface of Earth for millions of years. But until someone developed the tools and technology needed to extract that oil from deep under the ground and turn it into a useful fuel, it had little value. Labor Resources: Putting Human Capital to Work The time and effort people devote to producing goods and services in exchange for wages is called labor. This includes both physical labor, such as planting crops and building houses, and mental labor, such as writing legal briefs and programming video games. The quantity of labor available in a country depends on the size of its population and people’s willingness to work. The quality of that labor depends on how skilled these workers are, otherwise known as human capital. Human capital is the knowledge and skill that people gain from education, on-the-job training, and other experiences. “It is what you would be left with if someone stripped away all of your assets,” says author Charles Wheelan, “and left you on a street corner with only the clothes on your back.” The importance of human capital is almost impossible to overstate. Workers with high human capital are more productive and earn more money than those with fewer skills. This is why an airline pilot makes more money than a taxi driver even though they offer similar services. Airline pilots not only require much more intensive training, but they also move more people across further distances per day than do cabbies.

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Figure 2.2A The common pencil is produced by assembling natural resources from many parts of the world. The resources that come from plants are renewable. The mineral resources— zinc, copper, pumice, clay, and graphite—are not.

There is a strong correlation, or relationship, between a country’s level of human capital and its standard of living. A country like Japan, which is poor in resources but rich in human capital, can be among the world’s wealthiest nations. In contrast, the correlation between a country’s natural resources and living standards is weak. For example, Nigeria, which is rich in oil but poor in human capital, has a very low standard of living. Economist Gary Becker, who won a Nobel Prize for his work in human capital, estimated that about 75 percent of the wealth of a modern economy consists of the education, training, and skills of its people. “We really should call our economy a ‘human capitalist economy,’ for that is what it mainly is,” he said. “Indeed, in a modern economy, human capital is by far the most important form of capital in creating wealth and growth.” Capital Resources: Tools, Machines, and Buildings When most Americans use the word capital, they are thinking about money that they could invest in stocks, bonds, real estate, or businesses to produce future wealth. Economists sometimes refer to money used in this way Level: A

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as financial capital. To an economist, however, money by itself does not produce anything. What matters in the production process are the tools, machines, and factory buildings that money can buy. To avoid confusion, these concrete productive resources are sometimes called physical capital or capital goods. Looked at this way, capital consists of the tools, machines, and buildings used in the production of other goods and services. That last part—used in the production of other goods and services—matters. If you buy a car to drive to school and social events, it is a consumer good. If you buy a car to deliver pizzas for a restaurant, it is a capital good.

Figure 2.2B Since 1940, this country’s human capital—as measured by formal schooling—has increased steadily. Americans with college degrees can expect to earn at least one million dollars more over their lifetimes than high school graduates.

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as a screwdriver to technology as complicated as a supercomputer. Factories, office towers, warehouses, bakeries, airports, and power plants are forms of capital. So are roads, electrical grids, sewer systems, and the internet.

You can become an entrepreneur at any age. Facebook was created in 2004 by Mark Zuckerberg while a student at Harvard University. The site began as a networking site for Harvard students, but quickly expanded to include students at other schools, and then the public at large. By 2018, Facebook had over 2 billion active users every month.

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Since the beginning of the Industrial Revolution, capital has replaced labor in one area after another. This process began in the textile industry in England, where water-powered spinning machines and mechanical looms replaced spinners and weavers in the production of cloth. More recently, ATMs and online banking have taken over many services once handled by bank tellers. Robots have replaced assemblyline workers in automobile assembly plants. Each advance in physical capital, however, has created new needs for labor. Now, employees are needed to design, produce, and maintain the new machines. Putting It All Together: Entrepreneurship Entrepreneurship is a specialized and highly valued form of human capital. It involves the combining of land, labor, and capital in new ways to produce goods and services. Entrepreneurs perform several roles in the production process, including the four listed below.

Innovator. Entrepreneurs think of ways to turn new inventions, technologies, or techniques into goods or services that people will want. Strategist. Entrepreneurs supply the vision and make the key decisions that set the course for new business enterprises. Risk taker. Entrepreneurs take on the risks of starting new businesses. They invest their time, energy, and abilities— not to mention their own and often other people’s money—not knowing whether they will succeed or fail. Sparkplug. Entrepreneurs supply the energy, drive, and enthusiasm needed to turn ideas into realities. As entrepreneur Nolan Bushnell, founder of Atari and Chuck E. Cheese’s Pizza Time Theaters, has observed, The critical ingredient is getting off your butt and doing something. It’s as simple as that. A lot of people have ideas, but there are few who decide to do something about them now. Not tomorrow. Not next week. But today. The true entrepreneur is a doer, not a dreamer. Working Smarter Boosts Productivity Because all three factors of production are scarce, we will never be able to produce all of the goods and services people might want. However, we can increase the productivity of our economy by using these inputs more efficiently. Productivity is a measure of the output of an economy per unit of input. It is determined by dividing total output by one of the three inputs involved in its production: land, labor, or capital. 2020 Teachers' Curriculum Institute

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output productivity = input Productivity is stated as a ratio of output per unit of input. For example, in measuring the productivity of a lumber mill, you would begin with its output in a given period of time—in this case, the number of board feet of lumber produced in a week. You would then divide the output by one input, such as the hours of labor needed to produce that output. The mill’s productivity would be the ratio of board feet produced per hour. Because productivity is a ratio of output to input, it can be raised in two ways. The first is by getting more output from the same inputs. In the case of the lumber mill, this might be accomplished by organizing the production process in a more efficient manner. By doing so, the same number of hours of labor (one of the mill’s inputs) could produce more board feet of lumber (the mill’s output) each week. The second way to raise productivity is by getting the same output from fewer inputs. Looking again at the lumber mill, this could be done by finding a way to get more board feet of lumber out of each tree that the mill workers harvest. This improvement would enable the mill to produce the same amount of lumber (its output) using fewer trees (an input) and fewer workers to cut down the trees (another input).

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In the guns-versus-butter tradeoff, societies have to choose between security (“guns”) and civilian goods (“butter”). Most nations, however, try to find ways to balance security and living standards.

3. What Do We Give Up When We Make a Choice? Some decisions in life are easy. You probably don’t fret much over which option to choose from a school lunch menu. Other decisions are agonizing. Think back to the choice facing Mick Jagger when he realized he did not have enough time to both continue his studies and be the lead singer in a band. It was “very, very difficult,” he said later, since his parents wanted him to stay in college. But there was another reason this decision was so tough. In making his choice, Jagger had to give up something he valued (education) to get something he valued even more (a chance to become a rock star). Maximizing Utility: What We Want When We Choose The way economists see the world, people seek to make themselves as well off as possible by maximizing the utility of their decisions. They usually define utility as the satisfaction or pleasure one gains from consuming a product or service or from taking an action. But utility is more than that. We also gain utility by making choices that, while not all that pleasurable, are likely to improve our lives. Getting a vaccination or studying for a test may not be your idea of fun, but both should make you better off in the long run. 2020 Teachers' Curriculum Institute

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Maximizing utility is seldom easy. Whether choosing which television program to watch or which college to attend, we seldom have enough information to be absolutely sure we have made the best choice. Tradeoffs: What We Give Up When We Choose Every decision we make—even one as simple as deciding to read this text—involves giving up one thing for another. To gain time to read, you are giving up a variety of other things that you could be doing right now. Each of those other alternatives is a tradeoff. Like individuals, businesses face tradeoffs as they try to maximize the utility of their land, labor, and capital. Suppose an automaker decided that it could best use all of its factories and workers to build pickup trucks instead of cars. The tradeoff of its decision would be the loss of its passenger car business. Societies face tradeoffs as well. The classic example used by economists is the guns-versus-butter tradeoff, in which a society must choose between using its resources to produce guns (military goods) or butter (civilian goods). The term allegedly originated during World War I, when the American government had to decide to invest in either the war effort abroad or local interests. If the society chooses guns, it maximizes its security, but at the cost of lowering living standards. If it chooses butter, the society maximizes living standards, but at the cost of reducing security. Opportunity Cost: The Best Thing We Give Up to Get What We Want You may have noticed that each decision made by a society in the gunsversus- butter example involved a cost. The same is true for the decisions you make. When you choose one course of action, you lose the utility, or benefits, of the alternatives you did not choose. Were you to rank those alternatives, one would likely stand out as more attractive than the rest. While you might think of this option as your second-best choice, an economist would see it as your opportunity cost. The opportunity cost of any action is the value of the next best alternative that you could have chosen instead. Whether you have 2 alternatives or 200, your opportunity cost is simply the value of the next best one. Similarly, the opportunity cost of the automobile company that decided to produce only trucks was the money it would have made by continuing to produce passenger cars. Understanding the opportunity costs of the choices you face every day can help you make better decisions. Put yourself in this situation. You are in charge of dinner tonight. You can order food in for $45.00 plus $7 Level: A

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for delivery. You can go out to a restaurant and pick up the food yourself for $35.00 plus $3.00 for gas, but you will have to spend about 30 minutes driving to the restaurant and back. Or, you can drive to the grocery store and buy ingredients to cook dinner for $20.00 total. Between going to the grocery store, cooking dinner, and cleaning up afterward, you will have to spend another 2 hours with this option. One way to sort through these alternatives is to lay them out on a decision matrix like the one in Figure 2.3. The matrix lists all of the alternatives involved in the decision as well as the criteria, or factors, that might be used in evaluating those alternatives. In this instance, the factors are price, delivery cost, transaction time (how long it will take you to complete the purchase), and delivery time. The decision matrix does not tell you which alternative to choose, but it does clarify what you will gain and lose by choosing one over another. After analyzing the alternatives, you decide you really do not want to cook. If you choose to get delivery, your opportunity cost is $14 you would have saved by driving to pick up your food at a restaurant. If you choose to drive to the restaurant, your opportunity cost is the 30 minutes you spent driving. Knowing the opportunity cost of each alternative still does not tell you what to do. That depends on the value of $14 or 30 minutes of time to you. Should you have a better use for that half hour, such as doing homework, you probably would be better off having food delivered. If not, you might decide that trading a half hour of your time for a savings of $14 is the better choice.

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Figure 2.3 This decision matrix shows the tradeoffs associated with each of three purchase alternatives.

Making “How Much” Decisions at the Margin Note that in the dinner scenario, you were not facing an all-or-nothing, “have dinner or do without” decision. Instead, you were employing the thinking-at-themargin principle by looking at the marginal utility of one purchase alternative over another. Marginal utility is the extra satisfaction or pleasure you will get from an increase of one additional unit of a good or service. One alternative in the scenario left you with more time compared to the others. Another left you with more money.

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An understanding of marginal utility begins with the recognition that the amount of satisfaction we get from something usually depends on how much of that something we already have. Suppose you are so thirsty after a workout that you buy yourself a large bottle of apple juice. The first glass provides you with a high level of utility by quenching your thirst. The second glass is still satisfying, but its marginal utility is less because you are no longer so thirsty. The third or fourth glass has less utility as your thirst disappears and your stomach fills up. The fifth glass, should you continue drinking, might have a negative utility by making you feel sick. As this example shows, the marginal utility of something diminishes as we accumulate more of it. This explains why a homeless person is more likely to pick up a dollar bill off the sidewalk than a millionaire is. The dollar has a relatively high marginal utility to a person with little or no money. Conversely, the marginal utility of an extra buck to a person who already has a million dollars is relatively low. An economist would see this difference in behavior as an example of the law of diminishing marginal utility. According to this law, as the quantity of a good consumed increases, the marginal utility of each additional unit decreases. Most of the choices we face every day are “how much” decisions at the margin. Think back to the dinner example. How much more would you be willing to pay to eat dinner without having to invest time in getting it? How much time would you be willing to spend to eat dinner for less? Whenever you find yourself asking “how much” questions like these while considering a choice, you are thinking at the margin.

4. How Can We Measure What We Gain and Lose When Making Choices? In 1719, novelist and journalist Daniel Defoe published what would become one of the great classics of English literature: The Life and Strange Surprising Adventures of Robinson Crusoe. The novel tells the story of a sailor who spent 28 years marooned on a remote tropical island. In the novel, Crusoe survives using whatever resources the island had to offer. He becomes, in essence, a one-person economy. This makes him the ideal subject for exploring an economic model used to measure Level: A

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what we gain and lose when we decide how to use the resources available to us. Economists call this model a Robinson Crusoe economy. Measuring Tradeoffs Using the Production Possibilities Frontier The production possibilities frontier (PPF) is an economic model, in the form of a line graph, that shows how an economy might use its resources to produce two goods. The graph shows all possible combinations of those goods that can be produced using the available resources and technology fully. It also helps us see the tradeoffs involved in devoting more resources to the production of one good or the other. Figure 2.4A shows a PPF for Robinson Crusoe’s one-person economy. It focuses on the production of two foods that Crusoe had access to while on the island: coconuts and fish. In this hypothetical example, Crusoe can use the four hours he spends each day for food production by gathering coconuts or fishing. With the items at his disposal, he can harvest an average of 10 coconuts an hour in the forest or catch 10 fish an hour on the beach. The sloping line on the graph shows the various combinations of coconuts and fish that Crusoe can produce in a day. That line, known as the production possibilities curve , is straight in this simple case. In the more complex example you will look at next, the line bows outward in a curve. This line is also called the production possibilities frontier because it represents the best that this economy can do with its current factors of production. Without better tools (capital) or more time devoted to food gathering (labor), Crusoe will never produce more than any combination of coconuts and fish shown along the line graph.

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Figure 2.4A Selkirk’s production possibilities frontier shows all the combination of coconuts and fish that his one-person economy can produce. • At Points A and E, Selkirk devotes his time to producing just one food, either 40 coconuts or 40 fish. • At Point C, he divides his time evenly between coconuts and fish. His tradeoff compared to Point A is a loss of 20 coconuts in exchange for a gain of 20 fish.

Measuring Opportunity Costs Using the PPF A PPF can also be used to measure the opportunity costs of different production choices. Consider a hypothetical country that can use its resources to produce just two goods: cell phones and bananas. Its land can be used for cell phone factories, banana plantations, or some combination of both. Its workers can be trained to assemble phones, raise bananas, or both. Its capital goods consist of assembly-line equipment, farm machinery, or some of each.

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Consider an economic model in which only two goods are produced: bananas and cell phones. What resources are needs to produce the goods? How might the resources be allocated?

The graphs in Figure 2.4B show the different production possibilities for this two-goods economy, depending on how the country’s resources are allocated. Notice the bowed-out shape of the curve in this PPF. This shape indicates that the tradeoffs in this economy are not the same at every point on the curve. As a result, the opportunity cost—what the country gives up—when choosing to produce more of either good changes as one moves along the curve. One reason for this might be that not all of the country’s land is equally well-suited for bananas and factories. Banana trees planted on poor land may not produce well. Factories located far from city centers may have difficulty finding workers. Another reason might be that the country’s workers are not equally welltrained for banana and cell phone production. Suppose the country decides to increase its output of bananas. To do so, it would have to move workers from its factories to its plantations. The factory workers would arrive at the plantations with very different skills (such as knowing how to assemble electronic components) than the experienced plantation workers. They therefore would likely be less productive than workers who have been growing bananas for some time. Measuring Economic Efficiency Using the PPF The production possibilities frontier can also help us see how efficient our choices are. Economic efficiency is the result of using resources in a way that produces the maximum amount of goods and services. Every point on the PPF represents an efficient use of resources to produce that specific combination of outputs. But what if an economy does not use its 2020 Teachers' Curriculum Institute

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resources efficiently—or wishes to produce more than is currently possible given its resources? Both of those situations are illustrated in the second graph of Figure 2.4B. Every point in the shaded area inside the PPF represents a less efficient, but still attainable, production possibility. This reduced efficiency might be the result of a natural disaster or of a slowdown in the economy and a resulting rise in unemployment. Whatever the reason, within this shaded area, the economy is not functioning at full efficiency. Every point outside the PPF represents an unattainable production possibility. The economy’s resources are already being used to the max in order to reach the points on the curve. Beyond those points, the economy cannot produce more without added resources or improvements in efficiency.

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Knowledge you gain from your education and from work experience help you build human capital. Maximizing your human capital is one way to ensure you can get what you need.

Reflecting Economic Change Using the PPF 2020 Teachers' Curriculum Institute

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of an economy’s production possibilities at a specific moment in time. In the real world, these possibilities are constantly changing as economic conditions change. Improvements in productivity might mean more of one good can be produced using the same resources. Or the economy as a whole might expand or shrink. Both of these situations are illustrated in Figure 2.4C. When an economy grows, economists say that the PPF has “shifted to the right.” Productivity increases, jobs are more plentiful, and living standards improve. Likewise, when an economy shrinks, the PPF “shifts to the left.” Productivity falls, unemployment rises, and living standards decline. A number of factors can cause such shifts. What is important to remember is that while you cannot always have everything you want, the decisions you make in life may influence what you get. The most important of those decisions, from an economic point of view, is how to maximize your human capital. You may never make enough money to get everything you want. But with enough human capital, you should be able to get what you need.

Lesson Summary Life is full of choices and decisions. The study of economics helps us see why we have to choose among alternatives. It also gives us tools for thinking about what we stand to gain and lose when making life’s decisions. Why is what we want scarce? Scarcity exists because our wants, which are infinite, exceed our resources, which are finite. Unlike shortages, which are temporary in nature, scarcity is an inescapable fact of life. It means we can never have everything we might want. How do we satisfy economic wants? Goods and services are produced by bringing together the three factors of production: land, labor, and capital. Entrepreneurship is an essential part of the production process. Entrepreneurs combine land, labor, and capital in new ways to create products that satisfy economic wants. What do we give up when we make a choice? Every choice involves tradeoffs among alternatives. When making a decision, people generally try to maximize the utility, or satisfaction, they hope to gain by choosing one alternative over another. The opportunity cost of any decision is the value of the next-best alternative. Level: A

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How can we measure what we gain and lose when making choices? Economists use an economic model known as the production possibilities frontier to measure what we gain and lose when deciding how to use the factors of production in different ways. The model shows the tradeoffs and opportunity costs involved in producing more of one good at the expense of another. It also reminds us that even when an economy is working at peak efficiency, it will not be able to produce everything that we might want.

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ECONOMIC SYSTEMS

Economic Systems Who or what decides what you get?

Vocabulary Glossary Vocabulary Cards economic equity economic system traditional economy command economy market economy factor payment mixed economy free enterprise system

Introduction

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The U.S. economy offers grocery store customers an abundance of choices.

It is a Saturday afternoon, and across the United States, supermarkets are hopping and parking lots are full. Inside, brightly lit shelves are neatly stocked with every imaginable foodstuff and household item. Shoppers maneuver their carts through the aisles, deciding which products to buy from a seemingly endless array of choices. In 1989, Boris Yeltsin, a popular political leader from the Soviet Union and former chief of the Moscow Communist Party, visited a supermarket in Houston, Texas. It was one of many stops on a twoweek tour of the United States. To Yeltsin, the sight of ordinary people doing their weekly grocery shopping was anything but ordinary. In fact, to someone who had lived his whole life under communism, it was a revelation. A local newspaper reported that Yeltsin wandered the aisles, shaking his head in amazement. He sampled cheese and produce. He stared at the meat displays. He stopped customers to ask about the items in their carts and how much they cost. He asked the manager whether special training was necessary to run a supermarket. Level: A

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Yeltsin’s reaction was understandable. By the late 1980s, the state-run Soviet economy was in shambles. Consumer goods were scarce. People had to wait in long lines to buy food and other necessities. Store shelves were frequently empty of all but one or two poorly made goods. Even the privileged Communist Party elite did not enjoy such abundance as could be found in the average American supermarket. The stark contrast between American and Russian living standards was, as Yeltsin later wrote, “shattering.”

When I saw those shelves crammed with hundreds, thousands of cans, cartons, and goods of every possible sort, for the first time I felt quite frankly sick with despair for the Soviet people. That such a potentially super-rich country as ours has been brought to a state of such poverty! It is terrible to think of it. — Boris Yeltsin, Against the Grain, 1990 The visit confirmed for Yeltsin the painful truth about the Soviet economic system: it was a complete failure. In Houston and other American cities, he saw a very different economic system at work. In this lesson, you will explore different economic systems. You will learn how each one functions and who makes the decisions in each type of economy. You will also learn why some types of economy have succeeded while others have failed.

1. Who Gets What? How Do Societies Decide? If resources were unlimited, we all could have whatever we want. But resources are limited, so people must make choices about what to have and what to give up. This also forces societies to make choices. The larger and more advanced a society is, the more numerous and complex these choices may be. The Three Fundamental Economic Questions: What to Produce, How, and for Whom? In deciding how to allocate limited resources, every society—from a tribe of people living in the Kalahari Desert to a modern industrial nation like the United States—must answer three fundamental economic questions. Each society answers these questions differently depending on its priorities. The questions, however, are the same for everybody. 2020 Teachers' Curriculum Institute

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What goods and services are to be produced? Because resources are limited, no society can produce everything its people might want. This raises the question: What goods and services are most wanted and needed? For example, should the United States conserve wilderness areas for recreational purposes or open them up to logging or oil exploration? Should the U.S. steel industry produce more car parts or more beams for skyscrapers? What do consumers want or need more: sneakers or diapers? Teachers or dentists? Books or video games? With millions of possible products and many different interests competing for the same limited resources, the choices seem endless. Even the simplest societies face difficult choices. Vanuatu is a nation of several small islands in the South Pacific. Vanuatu’s economy has long depended on agriculture, but tourism is growing in importance. The question looming over Vanuatu’s people is about what will benefit them more—putting more resources into growing food or expanding tourist services? As a society, Vanuatuans must decide.

How are goods and services to be produced? The answer to this question is not as simple as it may seem. You know that goods and services are produced by combining the factors of production: land, labor, and capital. But how exactly is this done and in what combination?

Because the people of Vanuatu live on a series of small islands, one of their most scarce resources is land. They must make the economic choice of using their limited land for tourism or agriculture. Level: A

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Consider wheat production. How should land, labor, and capital be used to raise this essential grain? Should wheat be grown mainly on giant factory farms? That is the way an American agribusiness raises wheat. But in a different society, wheat might be grown on smaller family farms. Think about another example: hats. Should hats be crafted individually, by hand, or in factories by machines? Each society has to decide for itself the answer to these questions. At this point, you are probably wondering why a society as a whole has to make decisions about hats. Don’t hat manufacturers decide how to produce headwear? In the United States, they do, but that is because our society gives them that choice. Not all societies work this way.

For whom are goods and services to be produced? In other words, who gets what? This last question is a difficult one to answer because it raises the complicated question of fairness: who deserves what? Again, every society finds its own answer. Goods and services are distributed in a variety of ways. The ability to pay is the approach most of us know best. It essentially says that anyone who can afford to buy a hat can have one. Another approach is equal distribution. This approach was adopted by the Soviet Union before its collapse. Unfortunately, goods were in such short supply that lines formed for everything. Instead of distributing goods equally, the system favored those who got in line early and had time to wait. As a result, some people got more than their share, while others got nothing. This brings us to yet another form of distribution: first come, first served. As in the Soviet Union, this approach often prevails when quantities are limited. Goods such as concert and theater tickets are usually sold this way. In addition, there is distribution according to need. A soup kitchen does this when it provides meals to the homeless. So, does a public school that provides classroom aides for special education students.

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A Society’s Answers Depend on Its Economic Goals The way that a society answers the three economic questions will depend on its economic goals and social values. Most societies try to address some or all of the following six economic goals.

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In a society that values economic freedom, people are free to own, buy, and sell property. Sellers are also free to decide what price they are willing to set.

Economic freedom. In our society, we place a high value on economic freedom—the ability to make our own economic decisions without interference from the government. When you choose to buy something, whether it is a new game or a used car, you are exercising this freedom. If you choose to sell your car or go into business selling cars or anything else, you are exercising this freedom. A society that values economic freedom gives individuals and businesses the right to make decisions about how to use their resources, without government intervention. Economic efficiency. An efficient economy makes the most of a society’s resources. It delivers the goods by allocating resources in such a way that the greatest number of consumers get what they want with the least amount of waste. Because unemployed workers are a wasted resource, an efficient economy strives for full employment, which exists when all who want to work can find jobs. Economic equity. The term equity concerns fairness and justice. Economic equity involves the fair and just distribution of a society’s wealth. A society that values economic equity seeks to give everyone a fair share of the economic pie. But what constitutes a fair share? Is it fair that corporate executives make millions of dollars while retail workers earn minimum wage? Is it fair that women, collectively, tend to earn less than men? People often disagree on questions of equity, which makes it a difficult goal to achieve. 2020 Teachers' Curriculum Institute

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Economic growth. An economy is said to grow when it produces more and better goods and services. Economic growth is desirable because over time it leads to an improved standard of living. A century ago, middle-class Americans lived without cars, electricity, kitchen appliances, and indoor plumbing (not to mention antibiotics, frozen foods, and the internet). A key element of economic growth is scientific and technological innovation. New ideas and inventions bring new and improved products into the market, creating economic growth and raising living standards. Economic security. Every society has people who cannot provide for themselves. They may be too young, too old, too sick, or too poor to meet all of their basic needs. A society that puts a high value on economic security seeks to provide its less fortunate members with the support they need in terms of food, shelter, and health care in order to live decently. This is another economic goal in which people often disagree. For example, in the United States, access to affordable health insurance, which most people need to pay for healthcare, differs from state to state. Even when Americans agree that access to health care should be provided to everyone, they do not agree on how this goal should be accomplished. Economic stability. No one likes economic uncertainty. Societies therefore strive for the opposite: economic stability. Economic stability means that the goods and services we count on—electricity on demand, food and clothing in the stores—are there when we want them. Our jobs are there when we go to work each day. Prices are predictable, allowing us to plan ahead for purchases. Most societies consider these goals when making economic choices, but societies differ in the degree of importance in which they attach to each goal. Sometimes progress toward one goal can be achieved only at the expense of another. For example, when the government taxes our wages in order to pay unemployment benefits, it is contributing to society’s economic security. But it is also encroaching on our economic freedom to control our own resources. Societies, like individuals, must weigh the tradeoffs and costs of pursuing any particular set of economic goals.

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The Maasai people of East Africa are traditional herders. Livestock has been the mainstay of the Maasai economy for centuries. Cattle are used for food, building materials, and trade. Like people in other traditional economies, the Maasai decide what, how, and for whom to produce based on longstanding customs and traditions.

2. Who Decides What in Different Economic Systems? In the process of answering the three economic questions, every society develops an economic system. An economic system is the way a society coordinates the production and consumption of goods and services. Economic systems are as old as humankind, resulting in many different models. But if we strip away all of the cultural differences that exist between all of the societies that ever existed, we find that history has produced only three basic types of economic systems. There are those built on tradition, those based on the command of rulers, and those organized by free markets. Each system answers the three economic questions differently, and each emphasizes different economic goals. Traditional Economies: Decision Making by Custom The first and oldest economic system is the traditional economy. Traditional 2020 Teachers' Curriculum Institute

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economies have existed since the first clans of hunter-gatherers emerged in Africa. In a traditional economy, custom and tradition dictate what to produce, how to produce it, and for whom. Most traditional economies that survive today belong to indigenous people who live much like their ancestors did hundreds or thousands of years ago. The Maasai of East Africa, for example, are a seminomadic herding people. Livestock, primarily cattle, is an important part of their economy, and Maasai wealth is measured in cattle and children. The traditional Maasai diet consists primarily of meat, blood, and milk from cattle. The Maasai’s answer to the question of what to produce is cattle, because it is their centuries-old tradition to raise cattle. As for the question of how to produce, people in traditional economies engage in farming, herding, fishing, hunting, and the gathering of wild plants. Exactly who does what is determined by social customs, which can often divide labor along gender lines. Among the Maasai, for example, men build enclosures to protect the cattle from lions, boys graze the cattle, and women and girls milk the cattle. Among the KhoiSan people of the Kalahari Desert in Southern Africa, men hunt and women gather.

For whom to produce is another question decided by tradition and in which social hierarchies play an important role. A good illustration of this is the way meat is distributed among the Khoi-San people of the Kalahari. After a hunt, the kill is divided up, with a large share going to the hunter. The hunter gives some to relatives, and they give part of theirs to other relatives, all according to the accepted social order. In the end, everyone gets enough to eat. The highest goals of people in a traditional economy are economic stability and security. However, for most traditional societies this goal is increasingly difficult to attain. As modern economies exert an evergrowing influence, traditional societies are struggling to find a path to economic survival. Command Economies: Decision Making by Powerful Rulers The next economic system to develop is the command economy. In a command economy, decisions about what, how, and for whom to produce are made by a powerful ruler or some other authority. The earliest command economies originated in Mesopotamia, Egypt, China, and India about 5,000 years ago. As these civilizations became highly advanced, centralized governments arose that were headed by powerful rulers. These rulers then imposed their economic choices on Level: A

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society. However, at lower levels of society, much of the economic decisions were still guided by tradition. Rulers at the top of these early civilizations—kings, pharaohs, emperors — commanded the populace to devote economic resources to building projects or military excursions. Many thousands of people might be conscripted to build a pyramid, defensive wall, irrigation canal, temple, or road. In a preindustrial age, such projects took vast quantities of human labor. Often, many people would be drafted into a ruler’s army and sent into battle in distant lands. The primary goal of these ancient command economies was to accumulate wealth and goods for the ruling class while preserving economic stability. The many monuments these societies left behind are a testament to both the productive power of these economies and the excesses of their rulers. Market Economies: Decision Making by Individuals The newest economic system to emerge in human history is the market economy. A market economy depends on the decisions of individual producers and consumers. Note that when economists speak of “the market,” they are referring to the economic system within which buyers and sellers exchange goods and services. This is distinct from an everyday market, which is a place where people buy and sell goods.

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The Great Pyramid of Giza was built as a tomb for the Egyptian pharaoh Khufu around 2560 b.c.e. Historians estimate it took 20 years and tens of thousands of workers to construct the pyramid. In ancient command economies, economic decisions were made by rulers who used their power to force people to labor on monumental works, many of which still stand.

In a free market economy, the workings of the market are not planned or directed. No single person, business, or government agency tells producers or consumers what to do. Economic decisions are made voluntarily by millions of individuals guided by self-interest. The highest goals of a market economy are economic freedom and efficiency. Individuals and businesses are left at liberty to decide what, how, and for whom to produce. The producers of goods and services make these decisions based largely on consumers’ spending decisions. Because you are free to buy what you want, producers must compete for your money. This competition means that you, the consumer, have many choices. It also forces producers to use resources efficiently. If they do not, a competitor will find a way to offer the same good or service at a price that consumers will be more willing to pay.

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In a market economy, businesses can decide who they want to hire. Individuals are also at liberty to choose where they want to work. If they believe that they are underpaid at one place of employment, individuals can pursue a position elsewhere.

In a free market, individuals are encouraged to pursue jobs that allow them to make the most of their human capital. If one employer fails to pay an individual what they think they are worth, they can quit and seek employment elsewhere. Or, they can start their own businesses, perhaps even offering new products or services to consumers. You might expect that the result of this individual decision making and competition would be chaos. But, just the opposite is true. Markets are highly efficient at producing a large variety of goods and services that people find attractive and at prices they are willing to pay. It was this coordinating power of markets that Adam Smith famously described as “the invisible hand.” He wrote,

Every individual . . . neither intends to promote the public interest, nor knows how much he is promoting it . . . He intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention . . . By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. — Adam Smith, The Wealth of Nation , 1776 The Flow of Money and Goods in a Market Economy 2020 Teachers' Curriculum Institute

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markets work so well is that one person’s output always becomes another person’s input. Goods are produced and consumed. Money comes in and goes out. This flow is what keeps the economy running. Economists use the circular flow model, like that portrayed in Figure 3.2, to illustrate these interactions.

Figure 3.2 This economic model shows how money, goods, and resources circulate in a market economy. The model assumes that households own the factors of production. • The clockwise flow represents the movement of products and resources. Goods and services flow from firms to households. Land, labor, and capital flow from households to firms. • The counterclockwise flow represents the movement of money. Money flows from households to firms in payment for goods and services. It flows from firms to households as payment for land, labor, and capital.

In the simplified market economy, there are two kinds of participants: households and firms. A household is made up of a person or of a group of people living together. The model assumes that households own the factors of production. A firm is an organization that uses these factors to make and sell goods or services. The model also demonstrates two kinds of markets. One is the product market, in which goods and services are sold by firms and purchased by households. Your local mall or grocery store is part of the product Level: A

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market. The other is the factor market, in which households sell their land, labor, and capital to firms. A household, for example, might rent land to a firm. Or, members of a household might sell their labor to a firm for wages. They might loan money to a firm in exchange for interest payments, or they might buy a firm’s stock in the hopes of receiving dividend payments. The funds paid to households— whether in the form of rent, wages, interest, or dividends—are known as factor payments. This model is circular. Households buy products from firms with money that they receive in the factor market. Firms acquire land, labor, and capital from households using money that they receive in the product market. For example, you (as part of a household) might buy a pair of jeans from a firm with money that you earned by working at a local ice cream parlor (another firm). The ice cream parlor, in turn, pays you for your labor with money that it receives from selling ice cream cones to other households. All these transactions are conducted by people and businesses who want something for themselves. People work so that they can buy things. Firms employ people so that they can make things to sell. In a market economy, everybody chooses what is best for themselves. As Adam Smith observed, “It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest.”

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This Soviet-era postage stamp celebrates the heroes of the world’s first socialist command economy. Karl Marx and Frederick Engels, authors of The Communist Manifesto, are on the left. Vladimir Lenin, the revolutionary first leader of the Soviet Union, is to their right. Joseph Stalin, who ruled the Soviet Union with an iron fist until his death in 1953, is shown at the far right of the stamp.

Capitalism Gives Rise to Socialism and Communism Market economies emerged in Europe in the 1700s and began to grow rapidly in the 1800s. This economic growth was a direct result of the Industrial Revolution. During the Industrial Revolution, new inventions and manufacturing processes spurred the growth of industry. Individual investors, called capitalists, grew wealthy by accumulating capital, such as machinery, factories, and railroads. The term capitalism came to be synonymous with the free market Level: A

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economic system. The headlong growth of capitalism had profound effects on society. As more and better goods became widely available, people’s standard of living improved. However, capitalism did not improve the quality of life for everybody. The workers who filled the factories and mills labored under harsh conditions, often working extremely long hours for meager wages. Critics of capitalism blamed the capitalists for exploiting workers and keeping them in poverty. In 1848, economist Karl Marx and philosopher Friedrich Engels published The Communist Manifesto, in which they advocated the overthrow of capitalism. They proposed an alternative vision of society known as socialism. Socialism is a political and economic philosophy that calls for property to be owned by society as a whole, rather than by individuals, for the equal benefit of all. To bring about this socialist vision of society, Marx and Engels called on workers everywhere to revolt against their governments. They argued that once the workers had gained power, private property and the free market would be replaced with national ownership of industry and a more equal distribution of income. The final phase of socialism, in the view of Marx and Engels, is communism, a political and economic system in which all property and wealth are owned by all members of society. In a communist society, class differences— and the conflicts they create—disappear. Once that happens, government is no longer needed to keep order. Instead of self-interest, people in a communist society are guided by Marx’s famous slogan: “From each according to his ability, to each according to his needs.” Modern Command Economies: Decision Making by the State The ideas of Marx and Engels spurred the development of political movements dedicated to the creation of a workers’ paradise. But when the first successful communist revolution took place in Russia in 1917, it did not lead to the utopian society Marx had envisioned. Instead, the revolutionaries formed an authoritarian government that pursued its socialist goals with brutal force. The renamed Union of Soviet Socialist Republics, or Soviet Union for short, became the first modern command economy. In the Soviet Union, private ownership of property was forbidden and the state owned the factors of production. Economic planning was done by government committees of economists, production experts, 2020 Teachers' Curriculum Institute

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and political officials. These central planning committees attempted to perform the functions of a market. They decided what goods and services should be produced, as well as decided which farms and factories should get which resources to produce what was planned. Committees also controlled prices and wages and decided how goods and services were to be distributed. In theory, this kind of planning was supposed to ensure economic equity and security—two important goals of a modern command economy—but the reality was very different. The planning committees could not keep track of the millions of products and prices in the Soviet system. Two Soviet economists, Nikolai Shmelev and Vladmir Popov, described what happened when Goskomsten, the committee in charge of prices, raised the price that the government would pay hunters for moleskins.

State purchases increased, and now all the distribution centers are filled with these pelts. . . The Ministry of Light Industry has already requested Goskomsten twice to lower purchasing prices, but . . . [they] have no time. . . they have to keep track of another 24 million prices. —The Turning Point: Revitalizing the Soviet Economy, 1990 In this planned economy, shortages were common. Long lines would form to buy whatever goods suddenly became available, but once a customer got to the front of that line, choice was limited or nonexistent. Planners made matters worse by ignoring the incentives-matter principle. The wages paid to workers were determined by government committees, not by a worker’s ability or output. A poor worker could not be fired for slacking off, nor could a good worker be rewarded for working hard. Under this system, workers lacked incentive to produce high-quality goods or to innovate to increase productivity. As a result, production was slow and the goods produced were often far inferior to those produced in a market economy. The Soviet Union did succeed in increasing economic equity and security for their people. But what is the benefit to a guaranteed income if there is nothing to buy? What markets do effortlessly, command economies struggle to do. Central planning was so inefficient that the Soviet Union economy eventually collapsed. Since then, virtually all modern command economies have either failed or struggled to introduce market-based reforms. Level: A

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3. How Do Mixed Economies Divide the Decision Making? No country in the world today relies on a purely traditional, market, or command economic system. These systems represent theoretical extremes. Nearly all countries have mixed economies that fall somewhere in between these extremes. In a mixed economy, both the government and individuals play important roles with regard to production and consumption. But who decides what varies from one country to another. Government’s Role in a Mixed Economy: Protection, Regulation, and Public Benefits Every nation with a mixed economy forges its own balance between market freedom and government involvement. At the minimum, governments are needed to establish the institutions that enable markets to operate. Such institutions include a legal system to enforce laws and a stable system of currency. Without these institutions, the market would be unable to function. In many countries, people expect further government involvement. They want it to step in when the market operates in ways that society finds unacceptable. For example, many nations outlaw child labor. 2020 Teachers' Curriculum Institute

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Some governments limit the amount of pollution that industries can discharge. In the United States, the government regulates the manufacture of cosmetics, foods, and drugs because consumers want to know that products on the market are safe. Not all governments regulate the manufacturing of products to the same degree. Each society decides how involved the government will be in curtailing the freedom of the market.

A public lending library is an example of a valuable service to society that a free market is not likely to provide. Each society has to decide what goods and services it wants its government to provide.

Finally, government provides certain goods and services that markets do not always provide or do not provide enough of. Examples include public works, or government-financed projects such as dams, highways, and sewer systems. The market does not provide these goods because, as Adam Smith explained, the cost of providing them “could never repay the expence to any individual or small number of individuals.” What a government provides varies from country to country. In Canada and much of Europe, free health care is provided to every citizen. Some governments provide free college education or free day care. Governments that provide a high level of goods and services also tax heavily to pay for those goods and services. Again, these are economic choices that every nation makes differently. The Flow of Goods and Money in a Mixed Economy How does government participation in the economy change the flow of money and goods? The answer to this can be seen by adding government to Level: A

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the circular flow model. A government enters the flow of money and products through an economy in a number of ways. It purchases land, labor, and capital from households in the factor market. In the United States, the federal government employs just under 3 million civilian employees, making it the nation’s largest employer. A government also purchases goods and services from firms in the product market. As the nation’s largest employer, the federal government is also its largest customer, spending hundreds of billions of dollars a year on goods and services.

Figure 3.3A This economic model shows how government affects the flow of money, goods, and resources in a mixed economy. • Households supply taxes and labor to the government. • Firms supply taxes and products to the government. • The government supplies services to households and firms. It also pays households and firms for their labor and products, as well as sending transfer payments to households.

Governments also combine land, labor, and capital to produce and distribute goods and services. For instance, suppose a town decides it needs a library. The town government buys land and hires architects and builders in the factor market. Later, the town buys books, shelves, computers, and furniture in the product market. Finally, it hires librarians in the factor market. The end result is a public service that 2020 Teachers' Curriculum Institute

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the entire community can enjoy. Now, follow the flow of money in a mixed economy. You will see that a government collects taxes from both households and firms. It uses some of this money to pay for the goods and services that it buys from firms. It may also transfer some money back to households as payment for government benefits. Social Security checks, welfare payments, and unemployment benefits are examples of government transfer payments. The Mixed Economy Continuum: From Free to Repressed Although most of today’s economies can be described as mixed, the “mix” of market freedom and government control varies greatly from one nation to the next. Each year, the Heritage Foundation and the Wall Street Journal publish their annual Index of Economic Freedom. This index is a kind of scorecard that ranks the economic freedom of the world’s nations. It is a useful tool for understanding the variety of mixed economies. In 2018, Australia rated one of the most free economies in the world. Free markets dominate Australia’s mixed economy. All banks are privately owned. The economy is open to foreign investment and trade. Private property is very secure. Starting a business is easy, taking an average of only two and a half days. At the very bottom of the list is North Korea, which came in last of the 180 ranked nations. A communist country since 1948, North Korea still has a tightly controlled command economy in which the government directs all industries and businesses. Nearly all foreign trade is forbidden, and private property is severely restricted. What about countries that fall somewhere in between, such as Japan, South Africa, and France? All three have mixed economies dominated by the market system. All have relatively high levels of economic freedom and secure property rights. But they also have high tax rates, which are used to pay for an array of public services, such as government-provided health care. In these nations, people have decided that achieving economic equity and security for more members of society is worth giving up some measure of their individual wealth. Further down in the rankings is China, which is rated “mostly unfree.” China, which has had a communist government since 1949, is in transition from a command economy to a market-oriented system, but its mixed economy is still dominated by an authoritarian government. Level: A

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All Chinese banks are owned by the state. Private property is not secure, and internet use is tightly controlled by the government. Still, China allows more economic freedom than many countries. Cuba, for example, is rated “repressed” as its economy is dominated by the state. As in repressed North Korea, foreign investment in Cuba is severely restricted. Only five nations in the 2018 Index of Economic Freedom , plus Hong Kong, were rated “free.” In addition to Australia, these countries are Singapore, New Zealand, Switzerland, and Ireland. What do these countries have in common? All have mixed economies dominated by free markets. Most have democratic forms of government. They are also all among the wealthiest nations in the world. As Adam Smith might have predicted, the societies with the most economic freedom are also among the most prosperous.

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Figure 3.3B Whereas most countries today have mixed economies, the level of economic freedom their citizens enjoy varies widely. The Index of Economic Freedom ranks countries based on 10 indicators, including the ease of starting a new business, protection of property rights, and freedom from corruption. The 2018 rankings – from a high of 90 percent to a low of about 6 percent – are displayed on the map.

4. What Are the Key Characteristics of the U.S. Economic System? The high ranking of the United States on the Index of Economic Freedom is not surprising. Americans value their economic freedom, so much so that our economy is often described as a free enterprise system. In a free enterprise system, individuals own the factors of production and make decisions about how to use those factors within Level: A

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the framework of the law. Seven key characteristics of a free enterprise system are explored below. Economic Freedom As the term free enterprise suggests, the essence of our nation’s economic system is freedom—the ability of individuals to act in their own best interest in free markets. In practical terms, this means that we can buy what we want and from whomever we want. If we do not like what one firm is selling, we can take our business elsewhere. We are free to start businesses or to seek any job we choose. Firms are free to make what they want, hire whomever they choose, and set their own wages and prices. Because our economic system allows individuals and businesses so much freedom, it is often referred to as a laissez-faire economy. Economists use the term laissez-faire to describe a market economy that is relatively free of government intervention. (In French, laissezfaire means “let them do.”) But in fact, laws exist that limit what producers and consumers can do in the United States. Stores, for example, are not free to sell alcohol to teenagers. Businesses are not free to hire child laborers. Economic freedom does not give anyone the right to break the law. However, it does allow us to act in our economic best interest within the law. Competition Because virtually anyone can enter the market at any time, many rival sellers usually vie for customers’ business. The resulting competition is a hallmark of the free enterprise system. Competition provides an incentive for businesses to create new and better products and ways of serving customers. For consumers, this means more goods and services to choose from. Competition also encourages producers to use their resources efficiently in order to lower costs. When lower costs translate into lower prices, consumers win again. Equal Opportunity declared,

In 1776, the Declaration of Independence

We hold these truths to be self-evident, that all men are created equal, that they are endowed by their Creator with certain unalienable Rights, that among these are Life, Liberty and the pursuit of Happiness. Most Americans today understand these words to mean that we are born equal in terms of our rights, freedoms, and the opportunity to make the best of our talents and abilities. Our belief in the United 2020 Teachers' Curriculum Institute

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States as a “land of opportunity” is deeply rooted in our country’s history as a nation of immigrants. Nonetheless, our free enterprise system has not always offered equal opportunity to everyone. Women, African Americans, and other minority groups have had to fight discrimination in education and employment. Through the efforts of citizens and government intervention, these barriers to economic opportunity have begun to fall, providing more equal opportunities for every person to gain an education and compete in the marketplace.

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This young author is not taking any chances with her intellectual property. By copyrighting her school essay, she is protecting her property rights in the print, broadcast, and electronic media.

Binding Contracts In business, a contract is an agreement between a buyer and a seller. Contracts are used in all types of economic transactions. Even the receipt that you sign when you use a credit card is a contract. In our free enterprise system, people are free to decide what contracts they want to enter into—but once agreed on, a contract is binding. That means that both sides have to fulfill their ends of the deal. Because free enterprise depends on buyers and sellers honoring their agreements, it is important to have a legal system that upholds contracts. U.S. courts recognize the binding nature of contracts. They also recognize that people and businesses can run into financial problems and become unable to pay their debts. Bankruptcy is the legal process by which such situations can be resolved. Although bankruptcy allows people in debt to get a fresh start financially, a major downside is the negative effect bankruptcy will have on their credit reports, which will make it difficult to obtain loans in the future. Furthermore, not all debts are eliminated during bankruptcy. Property Rights

A necessary element of a free enterprise system is

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the right to own property. Property rights are the rights of those who own land, buildings, or other goods to use or dispose of them as they choose. In other countries, past and present, rulers have had the power to seize another person’s property for their own use. The U.S. Constitution protects against this abuse of power. It guarantees access to the courts in case of disputes about property. It further guarantees that an owner will be paid for property that is taken by the government for public use. These constitutional guarantees are crucial to the free market. Why would people buy homes or start businesses, unless they were certain that they would get to keep their property? The Constitution also protects intellectual property by empowering Congress to enact patent and copyright laws. Intellectual property refers to creations of the mind that have commercial value. A patent gives an inventor the sole right to make, use, or sell his or her invention for 20 years. A copyright similarly gives the creator of a literary or artistic work the sole right to reproduce, distribute, perform, or display the copyrighted work. Current copyrights last for 70 years beyond the life of the author. Why do we need intellectual property laws? Think about what would happen without them. As soon as a new invention (or book or song) became public, others would copy it and put it on the market. The inventor (or writer or composer) would therefore receive no reward for his or her efforts. Without a reward, inventors and creatives would have no incentive to invent new things or create new works. Patents and copyrights encourage creativity and innovation by guaranteeing that inventors and artists can profit from their creations. Profit Motive If any single force could be said to drive a free enterprise system, it is the profit motive. Profit is the money earned by a business after subtracting its costs of operation. The desire to make a profit is known as the profit motive. The profit motive is closely tied to the incentives-matter principle. Profits are our incentive to work or start businesses in the hope of making money for ourselves. Some people confuse the profit motive with greed or with stealing wealth from others. Most economists, however, see the profit motive positively as it is the reason most businesses exist. As Adam Smith observed, people produce goods and services in order to improve their economic situation—to make a profit. Limited Government Level: A

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system is a relatively limited role for government in the economy. In the United States, the government does not try to control firms. Nor does it often compete with firms. Government intervention in the economy is generally limited to several different areas.

Protecting property rights and contracts. The government enforces laws that protect property owners and patent and copyright holders. Promoting the general welfare. The government funds projects and programs that benefit society as a whole. Preserving competition. The government enacts laws that protect and preserve a competitive marketplace. Protecting consumers, workers, and the environment. The government requires businesses to ensure that their products do not harm consumers. It also imposes regulations on firms to promote workplace safety and to reduce pollution. Stabilizing the economy. The government works to keep the economy growing steadily rather than alternating between periods of boom and bust. Let’s return to the question we started with: Who or what decides what you get? In our economic system, the answer is both a who and a what. The what is the market, made up of millions of individuals who buy and sell goods every day on a strictly voluntary basis. The who is you, your family, and your friends, all exercising your freedom of choice as consumers. What are the effects of these choices? Later on, you will learn more about how the choices you and others make in the market help determine what you might get tomorrow.

Summary Because resources are always scarce compared to people’s wants, all societies must make choices about what to have and what to give up. How those choices are made depends on a society’s economic system. How do societies decide who gets what? Every society is faced with three economic questions: What goods and services should be produced? How should they be produced? Who should get what is produced? How a society answers those questions depends on its economic goals. These goals include economic freedom, efficiency, equity, growth, security, and stability. 2020 Teachers' Curriculum Institute

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Who decides what in different economic systems? Over time, societies have developed three economic systems to answer these questions. In a traditional economy, decisions are dictated by custom and tradition. In a command economy, a powerful ruler or government makes decisions. In a market economy, decisions are made by the interactions of individual producers and consumers. Each system emphasizes different economic goals. How do mixed economies divide the decision making? Most countries today have a mixed economy, in which both the government and individuals have a voice in economic decisions. Who decides what varies greatly. Some countries, including the United States, minimize government regulation of the market. Others, such as China, still exercise considerable government control over economic activities. What are the key characteristics of the American economic system? Americans describe their economy as a free enterprise system. This system has seven key characteristics. Economic freedom to buy and sell what we want and to work where we want Competition among firms, which try to attract customers with new and better products Equal opportunity to make the best use of our talents, abilities, and education Property rights that allow us to buy, own, and sell goods and intellectual property Binding contracts, which give us confidence that others will abide by their agreements The profit motive, which provides an incentive to work and start new businesses Limited government that regulates without controlling individuals, firms, or the market

Five Measures of Economic Well-Being What says more about the overall economic well-being of a nation: the average amount of money each person in the country spends each year? The amount of pollution the country emits? Or the average height of the adult population? The five economic indicators shown here use these and other criteria to assess the well-being of 10 countries. Four of the indicators are indexes, which use a formula to measure well-being. Level: A

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One—human height—provides comparative data. The United States ranks high by some measures and low by others. Which indicator do you think is the most valid? Nominal GDP Nominal gross domestic product is the value of all final goods and services produced during a given year, expressed in current prices. The four largest economies in the world, based on estimated 2018 GDP include the United States ($20,494), China ($13,407), Japan ($4,971), and Germany ($4,000). This is followed by a sampling of countries with lower GDPs, such as Brazil ($1,868), Canada ($1,711), and Russia ($1,630). Note that the dollar figures are given in billions. For example, $20,494 means $20,494,000,000,000, or $20 trillion. Per Capita GDP Per capita GDP is calculated by dividing a country's GDP by its population. The result —a country's average economic output per person—is a better measure than nominal GDP for comparing the living standards of two or more countries. The number one country in this ranking is Qatar, whose per capita GDP was $124,100 in 2017. Qatar has prospered in recent years due to its oil and gas reserves. Human Development Index (HDI) The Human Development Index is an economic indicator favored by the United Nations. It looks beyond a country's GDP to gain a broader perspective on well-being. The HDI combines per capita GDP with life expectancy, the adult literacy rate, and school enrollment. Based on this measure of well-being, the UN ranks countries according to how well they are doing at promoting human development. Happy Planet Index (HPI) The Happy Planet Index does not include any measure of GDP. Instead it measures the degree to which a country provides well-being to its people and the planet. The HPI is based on a combination of life expectancy, life satisfaction, and “ecological footprint”—the fairness and responsibility with which a country consumes its resources. The tiny nation of Costa Rica came in first in this ranking, with a value of 44.7. Chad came in last. Human Height Scientists who study human growth argue that a population's average 2020 Teachers' Curriculum Institute

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height is a better indicator of well-being than GDP or per capita GDP. People grow taller, they say, when they have more healthful diets, greater wealth, better housing, lower levels of pollution, and less disease and stress. Height is largely a function of genes—tall parents tend to have tall children. But nutrition and other environmental factors, these scientists insist, can explain differences in genetically similar populations. In their view, human height and well-being rise together.

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Gains from Trade How does trade make people better off?

Vocabulary Glossary Vocabulary Cards specialization division of labor voluntary exchange barter money economic interdependence absolute advantage comparative advantage

Introduction

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In rural Nepal, people produce most of what they need themselves.

Being a jack-of-all-trades sounds like a good thing, doesn’t it? It seems as if having a wide range of knowledge and skills, as well as the ability to perform many kinds of tasks, would lead to a more productive life. Yet, it is not necessarily so. It might be true if you lived alone on a desert island. But for the rest of us, being able to do everything for ourselves might not be an advantage. To illustrate this fact, economists Robert H. Frank, Professor of Economics, and Ben Bernanke, Chairman of the Federal Reserve from 2006 to 2014, give us the example of Birkhaman Rai, a man from a poor rural village in the country of Bhutan. In the 1960s, Birkhaman worked as a cook for Frank in Nepal, where Frank was a Peace Corps volunteer. Not only was Birkhaman an excellent cook, but he could also do many other things. He could butcher a goat, make furniture, thatch a roof, and build a house. Moreover, he could sew clothing, repair appliances, craft objects from tin, and even prepare home remedies. In short, Birkhaman was a jack-of-all-trades who had a much wider range of skills and abilities than most Americans. Level: A

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Frank and Bernanke pointed out that although Birkhaman was very talented, he was by no means unique in Nepal. In the recent past, many people in Nepal were able to perform a variety of tasks that we, as Americans, would hire others to do. What accounted for this difference? It might seem that people in Nepal did more things for themselves because they lived in a poor country where many people could not afford to pay others for their services. But then Frank and Bernanke offered another explanation. They argued that poverty was the result— and not the cause—of the jack-of-alltrades phenomenon in Nepal. “The Nepalese do not perform their own services because they are poor,” Frank and Bernanke wrote. “Rather, they are poor largely because they perform their own services.” Frank and Bernanke argued that instead of doing almost everything themselves, poor Nepalese would be better off specializing in the production of particular goods and services. This specialization is a hallmark of industrialization. It gained importance as a result of the division of labor during the Industrial Revolution and served to increase industrial production and, thus, trade. Specialization’s role in industry often means that it is absent from nonindustrialized societies. According to Frank and Bernanke, if the Nepalese adopted specialization, they could trade among themselves to obtain any goods and services they do not produce. The result, as the trade-makespeople-better-off principle tells us, would be more wealth and a better standard of living. It may be nice to know how to do many things, but that does not mean it is in your economic interest to do them. In this lesson, we will examine how specialization and trade can make people better off than they would otherwise be.

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Before industrialization, people produced yarn, often in their homes, by using a spinning wheel, the device shown in the photograph. They fed raw materials such as wool and cotton into the spinning wheel, which twisted the fibers into yarn.

1. How Does Specialization Lead to Economic Interdependence? If you had lived 200 years ago, there is a good chance you and your family would have been much more self-sufficient, like the people in Nepal in the 1960s. You might have grown your own food, built your own house, made your own tools, and performed many other tasks for yourself rather than depending on others. Although self-sufficiency may be an appealing idea, it is not necessarily Level: A

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economically productive. In fact, societies that emphasize selfsufficiency are less productive and have a lower standard of living than those that rely on specialization and trade. Why is this the case? Specialization Improves Productivity In The Wealth of Nations, Adam Smith wrote about the advantages of specialization, an approach to production in which individual workers become highly skilled at a specific task. Smith illustrated this principle by describing a pin factory.

One man draws out the wire, another straight[en]s it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head; to make the head requires two or three distinct operations . . . I have seen a small manufactory of this kind where ten men only were employed . . . [who] could, when they exerted themselves, make among them . . . upwards of forty-eight thousand pins in a day . . . But if they had all wrought [worked] separately and independently, and without any of them having been educated to this peculiar business, they certainly could not each of them have made twenty, perhaps not one pin in a day. —Adam Smith, The Wealth of Nations, 1776 Smith’s description illustrates the division of labor that arises from specialization. It also underscores the great efficiency and productivity that result when workers divide the individual tasks that make up a job and become expert at those specific tasks. Smith’s pin workers were far more productive when each worker specialized in one step of the manufacturing process. What was true for Smith’s pin factory in the late 1700s is also true for an entire economy today. An economy can produce more with the same inputs of land, labor, and capital when each person or business specializes in a skill or task. As productivity increases, more products and services become available to more people, and living standards rise for society as a whole. If specialization is so great, shouldn’t all societies specialize? The answer, said Smith, has to do with population density and isolation from large markets. He observed, for example, that specialization in the late 1700s was more developed in large British cities than in lesspopulated rural areas, such as the Scottish Highlands. 2020 Teachers' Curriculum Institute

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In the lone houses and very small villages which are scattered about in so desert a country as the Highlands of Scotland, every farmer must be butcher, baker and brewer for his own family . . . A country carpenter . . . is not only a carpenter, but a joiner, a cabinet maker, and even a carver in wood, as well as a wheelwright, a ploughwright, a cart and waggon maker. In big cities, however, where the market for each of these jobs was large, different specialists would have performed these tasks. These workers could specialize because they knew that there were enough customers to sustain them. But markets in rural Scotland were too small, and the region too isolated, to support a range of specialists. Therefore, people had to perform a variety of tasks to earn a living and to satisfy their wants. In the 1960s, a similar scenario existed in Nepal, one of the most remote and isolated countries in the world. Nepal actually had a higher population density than many countries, including the United States. However, the country’s rugged, mountainous terrain and relatively undeveloped transportation system limited contact among different regions and with neighboring nations. These factors made trade difficult and helped keep Nepal’s markets small, thus discouraging specialization. Today, these factors still affect the country but to a lesser extent. The United States presents a very different picture. Beginning in the second half of the 20th century, much of this country increasingly became linked to other regions and the rest of the world through an advanced system of transportation and communications. This system has promoted trade and the growth of markets and encouraged the development of a highly specialized economy. This specialization has been evident in the variety of jobs performed by American workers. The U.S. Department of Labor’s Occupational Outlook Handbook, first published in 1948, lists thousands of types of jobs. These jobs range from familiar occupations like carpenter, engineer, and teacher to more specialized jobs like budget analyst, recreational therapist, and violin repairer. The people who work in these jobs are specialists, each pursuing a particular career. Specialization Encourages Trade When people specialize, they no longer produce everything for themselves. As a result, they must trade with others to obtain those things they do not produce. They trade not only to satisfy their own wants but also to focus on what they do best. As economist and author Charles Wheelan pointed out, “We trade with Level: A

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others because it frees up time and resources to do things that we are better at.”

At the start of the Industrial Revolution, factories using specialized machines began to replace hand spinners and weavers in the production of cloth. These historic mechanical looms can still be seen in operation at a museum in Lowell, Massachusetts.

Wheelan noted that we could, in theory, do many more things for ourselves. We could raise our own livestock, for example, and not have to pay others for meat, milk, and cheese. But that would require an enormous amount of time and energy, and the opportunity cost—as measured by all the other things we could be doing—would be very high. Besides, what do most of us know about meat and dairy production? In the end, we are better off when we specialize in activities suited to our skills and trade for everything else. Trade is a voluntary exchange in which both parties give up something in order to get something else they want. People trade because it is in their mutual interests. As economists James Gwartney, Richard Stroup, and Dwight Lee pointed out in their book Common Sense Economics, “The foundation of trade is mutual gain. People agree to an exchange because they expect it to improve their well2020 Teachers' Curriculum Institute

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being.” In traditional economies, trade often takes the form of barter, the direct exchange of one good or service for another. For example, a farmer and a shepherd might agree to barter by exchanging a basket of potatoes for a bag of wool. Barter works well when there is a coincidence of wants—that is, when two people have something that they want to exchange with one another. In market economies, money is used instead of bartering. Money is a medium of exchange that can be traded for goods or services or used to pay debts. Money is useful only when its value is generally accepted throughout society. It facilitates trade because it is easy to carry and convenient to use for commercial transactions. Trade Creates Economic Interdependence Whether carried out through barter or with money, trade leads to economic interdependence. When we specialize and trade, we depend on other people or countries to produce many of the goods and services we want. A modern economy consists of a complex web of economic links that connect producers and consumers throughout society and across borders.

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This economic interdependence is apparent in the foods that an American may eat for breakfast. For example, breakfast might begin with a glass of juice made from Florida oranges. It could then be followed by toast made from Kansas wheat, eggs from Iowa, or hash browns made from Idaho potatoes. We might also enjoy a cup of coffee made from Colombian coffee beans. In other words, our breakfast depends on food produced by people in many different places, both domestic and international. Like Adam Smith, our country’s founders believed that trade and economic interdependence are essential to a nation’s economic growth. In the years just after independence, the new country experienced problems with states erecting trade barriers against each other. These trade barriers, which included tariffs and other measures to limit interstate trade, were designed to protect local industry and promote self-sufficiency. However, they prompted conflicts between states and made it difficult for the country to develop a unified national economy. The framers of the Constitution encouraged the growth of a national market by giving Congress alone the power to regulate interstate commerce. Article I, Section 8, also known as the Commerce Clause, states, “Congress shall have Power . . . To regulate Commerce with foreign Nations, and among the several States.” This clause empowers the national government to promote trade and economic interdependence among the states. To that end, the federal government maintains an interstate highway system and regulates navigation on interstate rivers and lakes. These government actions helped build and continue to support a large and prosperous national economy.

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2. How Do People and Nations Gain from Specialization and Trade? In a Robinson Crusoe economy, which we learned about in Lesson 2, the economy is made up of a single person who is both the producer and the consumer of whatever goods he or she is able to produce. In the case of Crusoe, who is stranded on a desert island, his lack of contact with the outside world means he has no chance to improve his standard of living through trade. Suppose, however, that a second castaway, a young man named Jim Hawkins, were to wash up on the island one day. Now, Crusoe would have someone to talk to as well as a potential trading partner. But would trade make life better for either Crusoe or Hawkins? To find out, consider the following scenario. The Castaways’ Dilemma: Self-Sufficiency or Interdependence Shortly after Hawkins’ arrival, Crusoe tells him about the island’s two main economic activities: collecting coconuts and fishing. Right away, the castaways face a critical question: would they be better off working separately and fending for themselves or joining forces and working together? As it turns out, Hawkins is a more efficient worker than Crusoe. He is younger, stronger, and better at almost everything, including collecting coconuts and fishing. As a result, he enjoys an absolute advantage in food production. Figure 4.2A shows how many coconuts and fish each castaway is able to collect in a given amount of time. Crusoe can harvest 10 coconuts or catch 10 fish in one hour, for a total of 40 coconuts or 40 fish in a four-hour workday. Hawkins can harvest 30 coconuts or catch 15 fish in an hour. In four hours, he can pick 120 coconuts or catch 60 fish.

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Figure 4.2A Robinson Crusoe was less productive than Jim Hawkins at food production. Hawkins had an absolute advantage in both harvesting coconuts and collecting fish.

At first, the two men decide to work together and equally share the food they produce. Hawkins soon begins to wonder, however, whether he might be better off moving to the other side of the island and working for himself. Based on his absolute advantage as a food producer, he concludes that it is in his interest to go it alone. At the time, three centuries ago, most people would have agreed with Jim Hawkins’ decision. What Jim Hawkins Missed: The Benefits of Comparative Advantage A century later, however, new economic insights might have led Jim Hawkins to a different conclusion. Those insights came from the pioneering work of the English economist David Ricardo, who, in 1817, developed the theory of comparative advantage. Comparative advantage is defined as the ability to perform a task at a lower opportunity cost than someone else. Opportunity cost, you will remember, is the value of what you give up to do something. As a producer, you have an absolute advantage if the time and labor required for you to produce something is less than it is for another producer. But you have a comparative advantage if your opportunity 2020 Teachers' Curriculum Institute

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cost is less than another producer’s opportunity cost. Ricardo’s breakthrough was to see that, regardless of absolute advantage, people could benefit from specializing in those activities in which they had a comparative advantage. Ricardo developed this principle in response to new English import tariffs known as Corn Laws. These tariffs placed a tax on imported grain in order to raise its price and protect English grain growers, who could not compete with cheaper foreign grain. This tariff helped farmers and wealthy landowners, but it hurt factory workers, who could not grow their own food and had to pay more for their bread. Ricardo argued that allowing cheap grain to enter England would force the English to cut back on grain production and to instead concentrate their resources on manufacturing, which was increasingly where their advantage lay. In other words, English producers should specialize in goods in which they had a comparative advantage and then trade with foreign producers. The results, Ricardo said, would benefit society as a whole. Calculating the Opportunity Costs of Going It Alone The production possibilities frontiers (PPFs) in Figure 4.2B show how Ricardo’s theory can be applied to Crusoe and Hawkins. Remember that a PPF shows how much of two products or services a person or an economy can produce in a given amount of time.

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Figure 4.2B These PPFs show the amounts of coconuts and fish that Crusoe and Hawkins produce in a four-hour day.

Crusoe’s PPF shows that he can produce 40 coconuts or 40 fish in four hours. If he divides his time between the two activities, he can produce a combination of coconuts and fish in varying amounts. For example, Point A on the graph indicates that Crusoe can collect 20 coconuts and 20 fish in a typical four-hour day. According to Jim Hawkins’ PPF, in addition to his daily rate of 120 coconuts or 60 fish, he can produce mixed quantities, such as 90 coconuts and 15 fish. This mixed quantity is represented by Point B. The PPFs clearly show Hawkins’ absolute advantage in food production. But do they indicate any comparative advantage for either Crusoe or Hawkins? To answer this question, we must first calculate the opportunity cost associated with each activity. Crusoe’s data show that for every 10 coconuts he harvests, he gives up the opportunity to catch 10 fish. So, his opportunity cost for each coconut is 1 fish, and his opportunity cost for each fish is 1 coconut.

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Figure 4.2C Crusoe and Hawkins have different opportunity costs for gathering food. A comparison of their opportunity costs shows where each man’s comparative advantage lies.

Hawkins has different opportunity costs. For every 30 coconuts he picks, he gives up the opportunity to catch 15 fish. Therefore, Hawkins’ opportunity cost for each coconut is ½ a fish, but his opportunity cost for each fish is 2 coconuts. Both men’s opportunity costs are shown in Figure 4.2C. As Figure 4.2C shows, Hawkins’ opportunity cost for collecting coconuts is lower than Crusoe’s: ½ a fish for Hawkins versus 1 fish for Crusoe. This gives Hawkins a comparative advantage over Crusoe in harvesting coconuts. On the other hand, Crusoe’s opportunity cost for fishing is lower: 1 coconut for Crusoe versus 2 coconuts for Hawkins. This means that Crusoe has a comparative advantage over Hawkins in fishing, even though he does not have an absolute advantage. Specialization Based on Comparative Advantage Benefits Both Trading Partners According to Ricardo’s theory, Crusoe and Hawkins should each specialize in the activity in which he has a comparative advantage. Therefore, Crusoe should fish and Hawkins should harvest coconuts. They could then trade with each other to Level: A

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obtain the product they do not produce. But would this deal work to their benefit? Figure 4.2D shows how each castaway might gain from trading based on comparative advantage. The first two columns provide production and consumption values for both men without specialization and trade. These columns contain the values represented by Points A and B in Figure 4.2B.

Figure 4.2D By specializing and trading, the castaways could produce and consume more food. Neither man, however, would have to work any harder than if he had fended for himself.

The next two columns show production and consumption values if the castaways were to agree to specialize and then trade 17 fish for 25 coconuts. The production values show how much each man could produce by specializing. The consumption values indicate how much of both products the men could have if they then traded with each other. The last column shows what each man could gain from this trade. Crusoe would have the 25 coconuts he got from Hawkins, along with the 23 fish he did not trade. His decision to trade would result in a gain of 5 coconuts and 3 fish. As for Hawkins, after trading 25 coconuts to Crusoe, he would still have 95 left—5 more than he would have had if he had chosen to go it alone. He would also have the 17 fish he got from Crusoe—2 more than he 2020 Teachers' Curriculum Institute

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would have had without trade. So, both castaways would gain from specialization and trade. The PPFs in Figure 4.2E show the original production possibilities for the castaways, along with the increased amounts they would receive through trade. The new amounts, represented by Points A’ and B’, sit outside the PPF curve, indicating the gains the castaways would have made from trade.

Figure 4.2E The theory of comparative advantage says that both producers and consumers stand to benefit from specialization and trade. These PPFs show the gains from trade possible for Robinson Crusoe and Hawkins.

Comparative Advantage Applies to Nations as Well as Individuals What is true for individuals is also true for nations, including the United States. When the principle of comparative advantage is allowed to guide who produces what—for example, Florida farmers growing oranges and Idaho farmers growing potatoes—society usually benefits. Some of the factors that give rise to comparative advantage, such as climate and natural resources, may be fairly obvious. The main reason Florida has an advantage over Idaho in orange production is that oranges grow better in warm climates. Likewise, Nevada has a comparative advantage in gold production because of its gold deposits. Level: A

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Saudi Arabia excels in oil production because of its abundant oil reserves, while Canada can produce timber from its vast forests. When it comes to farming, mining, forestry, and fishing, geography determines where comparative advantage lies. Other factors—including education, wage levels, and technology differences— also play a role in determining comparative advantage. Most developed nations, such the United States and Japan, with their many colleges and universities, have a highly skilled, high-wage workforce. This gives these countries a comparative advantage in the development of advanced technologies, such as computer systems. Less-developed nations, on the other hand, tend to have less skilled, lower-wage workforces. Such countries often have a comparative advantage in the production of assembly-line goods, like clothing, that do not require highly skilled labor. The beauty of comparative advantage, as economists see it, is that it stands to benefit all trading partners. Countries with abundant resources, such as plentiful natural resources and high human capital, can actually gain more by specializing in what they do best and trading with other countries. However, even countries with no absolute advantages can benefit. They need to find what they can produce at a lower opportunity cost than other countries—their comparative advantage—and trade.

3. How Does Trade Make Us Wealthier? The principle that trade makes people better off is fundamental to the economic way of thinking. Another way to state this principle is that trade raises our standard of living and makes us wealthier. To appreciate this, try imagining life without the volume of trade we enjoy today. What would it be like? You might wake up in the morning to a cold house that your family built for itself. Because there would be no gas or electricity, which is only available through trade, you would build a fire from wood you helped to gather and chop. For breakfast you would eat food that your family produced, perhaps in a backyard garden. Of course, you would have no appliances to cook with— no toaster or microwave—because these things also depend on trade. You would put on clothes made at home, perhaps using wool from sheep you raised. Then, unless your family owned a horse—cars and bikes are out of the 2020 Teachers' Curriculum Institute

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question—you would probably walk to school. This imaginary scenario gives you an idea of how much harder life would be without trade. The fact is that trade does make us wealthier. Trade does this in three main ways. It puts goods in the hands of those who value them. It increases the quantity and variety of goods. It lowers the cost of goods.

As specialization and trade have increased in recent decades, more packaged foods, similar to those commonly sold in developed nations, have become available in Nepal.

Trade Moves Goods to People Who Value Them Level: A

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increase the value of goods, even when nothing new is produced. Think about a secondhand item you might buy online or at a flea market or garage sale. The fact that this item is for sale and that you are willing to buy it means that it has more value to you than to the person who is selling it. Otherwise, there would be no exchange. Trades of this kind move goods from people who value them less to people who value them more. Even though the product has merely changed hands, its value has increased. Here is a simple example of how a voluntary exchange can increase the value of goods. Imagine that you own a baseball cap that is practically new but does not fit you. A friend of yours owns a soccer ball she no longer wants. She wants your hat and you want her soccer ball. So, you trade. Why? Because you expect to be happier or better off afterward. Each good has more value for its new owner than for its previous owner. When we trade for things we value, our wealth increases. Most people define wealth as money and the things money can buy. But economists define wealth more broadly. Economist Michael Bade defined wealth as the total value of all the things a person owns. Notice that he did not say the total monetary value. This implies that wealth, which is often measured in dollars and cents, can also be measured in other ways. As economist Paul Heyne pointed out, “Wealth, in the economic way of thinking, is whatever people value,” which is another way of saying that trading for a used soccer ball can make you wealthier if a soccer ball is what you really want. Trade Increases the Quantity and Variety of Goods Available At the start of this lesson, you read about Birkhaman, the jack-of-alltrades who was skilled at many jobs. In Nepal, where he lived, modern consumer goods were once relatively scarce, especially in rural areas. In contrast, the United States and other highly developed nations have had access to consumer goods of all kinds since the 19th century, when many embraced specialization. Specialization has enabled these countries to produce more goods for their own use and for trade with other countries. This trade, in turn, has provided access to a range of goods from around the world. As a result, the quantity and variety of goods available in the developed world has been, and continues to be, enormous. Just think about the choices you have as a consumer. If you want to buy cheese, for example, you can go to a supermarket and choose from many different kinds. You can buy cheddar or Swiss, Brie or Colby, Monterey Jack or Camembert, and those are only a few of the choices. 2020 Teachers' Curriculum Institute

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The variety is mind-boggling. In Nepal, however, the selection tends to be more limited, particularly outside the main cities. At a store in a small village, for example, there might be just one type of cheese. However, this will likely change as the Nepalese economy becomes more specialized. Ultimately, in a specialized economy with abundant trade, the variety and quantity of goods are far greater. As a result, the society is wealthier, and more people are materially better off. Trade Lowers the Cost of Goods In addition to making more goods available, trade lowers the cost of those goods. It can do this in two ways. First, trade lowers the cost of goods by opening markets to less costly goods from other places. Countries that have a comparative advantage in the production of certain goods may be able to provide those goods to another country’s consumers at a lower cost than American producers can. Second, trade can lower the cost of goods by expanding markets for products. Larger markets, in turn, allow producers to take advantage of the savings that come with mass production, or large-scale manufacturing. For example, a company that produces thousands of loaves of bread each day might be able to buy its flour at a much lower cost than could a small neighborhood bakery. It can then pass those savings along to consumers by lowering the price of its bread.

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Figure 4.3 The impact of trade on the goods and services available to consumers can be seen in the evolution of the cell phone. Introduced in 1983, the first cellular phone weighed two pounds, sold for $3,995, and did nothing but make phone calls. Today’s cell phones weigh under five ounces, can be bought for less than $200, take photos and videos, send text messages, provide access to e-mail and the internet, have multiple apps, and enable users to play games and stream content. As cell phone producers introduced smaller, cheaper phones, the number of U.S. cell phone subscribers soared.

Trade Creates More Winners than Losers Nations generally benefit by expanding trade across their borders. This is true for both rich and poor countries. As world trade has expanded, the availability of goods has increased while costs have decreased. Trade also supports economic growth, efficiency, and greater innovation. As the authors of Common Sense Economics point out,

The growth of international trade has made it possible for the world to produce a larger output and achieve a higher 2020 Teachers' Curriculum Institute

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level of consumption than otherwise would have been the case. . . . The poor in particular have benefited from the freer trade, and worldwide, nearly a billion people moved out of extreme poverty in the twenty years from 1990 to 2010. —James D. Gwartney, Richard L. Stroup, Dwight R. Lee, Tawni H. Ferrarini, and Joseph P. Calhoun, Common Sense Economics, 2016 Not everyone gains from expanding global trade, however. Cheap imports from countries with a comparative advantage may take business away from American producers and even force them out of business. When U.S. factories close, American workers lose their jobs. This is a reason why workers and communities affected by plant closings often oppose free trade. Most economists agree, however, that expanding trade is good for Americans and the U.S. economy as a whole. Although some people are harmed by foreign competition, most Americans benefit. Economist Tim Harford notes,

. . . it is simply not possible for trade to destroy all of our jobs and for us to import everything from abroad and export nothing. If we did, we would have nothing to buy the imports with. For there to be trade at all, somebody in America must be making something to sell to the outside world. —Tim Harford, The Undercover Economist, 2012 If trade makes people better off, what does this mean for you? It suggests that you, too, can use comparative advantage to improve your life prospects. To find your comparative advantage, you must first decide what you like to do and can do well. If you focus on your strengths and specialize in what you do well, you will be making use of your comparative advantage.

Summary We live in a world in which people and nations are economically interdependent, a result of specialization and trade. The benefits of trade can be seen in increased wealth and a higher standard of living. Level: A

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How does specialization lead to economic interdependence? When people specialize, the resulting division of labor increases productivity. However, those who specialize must trade to obtain what they do not make themselves. This trade gives rise to economic interdependence. How do people and nations gain from specialization and trade? The principle of comparative advantage is what enables producers to gain from specialization and trade. By producing goods or services that have the lowest opportunity cost and then trading, people and nations end up being more efficient and productive. How does trade make us wealthier? Trade makes societies wealthier by moving goods to people who value them the most. Trade also increases the quantity and variety of goods and lowers the cost of goods.

Economic Factors that Guide the Location of Industry: Two Case Studies This essay examines economic factors that help guide the location of industry, followed by two mini-case studies that illustrate those factors.

The Factors Various factors help determine where industries are located. Absolute and comparative advantage are two general factors. Absolute advantage means that a firm can produce a good or service using fewer resources than its competitors. Comparative advantage means that production can be carried out at a lower opportunity cost. These general principles often influence the location of industries. In addition, economists cite seven specific factors that may influence where industries are located. 1. Proximity to markets: Industries generally benefit from being close to their customers. Proximity reduces shipping rates and, in the case of perishable goods, helps preserve product quality. Of course, many industries serve a national or global market and therefore cannot be located near all their customers. 2. Easy access to raw materials: Industries must have good access 2020 Teachers' Curriculum Institute

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to the raw materials used in production. Proximity to sources of raw materials also helps industries reduce shipping costs. 3. Availability of labor: Industries benefit when they can count on a good supply of qualified workers. Firms typically locate in areas where an adequate workforce is available. 4. Wage rates: Industries also tend to locate in areas where wage rates are favorable. By keeping labor costs down, firms can offer their products at a lower cost and have a better chance of earning a profit and staying in business. 5. Cost of land and impact of tax rates: Industries may make decisions on location based on the cost of land and the impact of local taxes. They may choose to open a plant in an area where land prices and tax rates make it more affordable to do business. 6. Government support: In some cases, industries may choose to set up operations in areas where they can get government support. That support, which might take the form of government subsidies or reduced taxes, is often designed to boost local economies. 7. Access to transport: Industries also tend to locate in areas that have good transportation infrastructure, including highways, airports, railroads, and ports. Although close proximity to markets and raw materials is useful, most industries also require good shipping facilities to support the production and distribution of goods.

Case Study: The Ethanol Industry in the Midwest The American ethanol industry illustrates many of the factors cited above. Ethanol is a biofuel made from such plants as corn, sugarcane, and sugar beets. Ethanol production has increased substantially in recent years as part of the effort to reduce U.S. dependence on carbonbased fuels, such as gasoline. Most American ethanol is produced from corn. The majority of U.S. ethanol producers are located in the upper Midwest, in a region known as the Corn Belt. This location gives biofuel producers easy access to their principal raw material. Situated in the middle of the country, they are also reasonably close to many of the country's major population centers. Farmland is readily available, and in many cases already planted in corn. Farm labor is also available. In its quest to lessen dependence on oil, the government has given a boost to the ethanol industry by providing subsidies and tax breaks to ethanol producers. Federal energy laws requiring the increased use of ethanol in automobile fuel have also promoted ethanol production. Finally, Midwestern ethanol plants are close to major highway and rail systems, allowing easy shipping to markets. Level: A

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Case Study: The High-Tech Industry in Silicon Valley The high-tech computer industry is quite different from the ethanol business, in part because it does not rely on a particular raw material. Nevertheless, the location of high-tech firms still corresponds to several of the factors that affect industry in general. Those factors are apparent in the growth of California's Silicon Valley, the center of the high-tech industry, which is located in the San Francisco Bay Area. The first two factors listed above—proximity to markets and access to raw materials—are not essential to the location of Silicon Valley. Nor are wage rates and access to land critical factors. The most important factors are the presence of a skilled workforce, government support, and access to good transportation and other forms of urban infrastructure. Silicon Valley owes much of its success to the presence of a large, highly educated workforce in the Bay Area. It sits adjacent to Stanford University, one of the nation's leading research institutions. The University of California at Berkeley is also nearby. Both universities have provided brainpower and technical resources critical to the growth of the high-tech industry. The Bay Area has also long been home to government research projects, many of them military-funded, focusing on new technologies. The high-tech industry was able to take advantage of this history of government funding to support its own research and product development. In addition, the Bay Area has well developed transportation and communications networks that facilitate the work of high-tech firms. All these factors have been essential to the growth of the high-tech industry in Silicon Valley.

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E C O N O M I C I N Q U I R Y : I M...

Improving a Country’s Economy Economic Question: How can you improve a country’s economy?

Inquiry Introduction In this unit, you learned about the structures that determine a country’s economic health and how various economic systems are utilized by different governments. You also learned about the vital role of trade in a country’s economy. Now, you will apply what you have learned to this Economic Inquiry. You will investigate the Economic Question in order to develop strategies for improving a country’s economy.

Storyline Suppose you are part of a group of economic advisers looking to provide aid to countries with moderate to little economic freedom. You will examine different factors that affect these countries’ economies. As economic advisers, you will be assigned to evaluate the economic freedom of a single country. Then, you will plan and present a proposal to help improve that country’s economy.

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In market economies, individuals have the power to make financial decisions for themselves, and businesses have the power to determine the goods and services they provide. In command economies, the government has greater restrictions over how businesses and individuals can amass wealth.

Background In this unit, you learned about three economic systems: traditional economy, command economy, and market economy. Regardless of the economic system, decisions about a country’s economy are made by its government. The type of government a country has can determine the economic freedoms its citizens experience. The health of a country’s economy is not solely determined by the wealth amassed by the government and its people. In some cases, wealth may be concentrated in the hands of a select group of elite citizens while most citizens live below the poverty line. In other cases, wealth may be concentrated in the hands of a select few government leaders. For example, Nigeria as a country has a lot of wealth, but the majority of this wealth does not contribute to individual economic freedom. In times of crisis, countries with a healthy economy may be called on to support countries with unhealthy economies.

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In this activity, you will identify the factors that undermine economic freedom of a country and determine a strategy to make positive change.

Inquiry Process As you consider the Economic Question, you may wonder what factors are used to measure economic freedom. Be sure to pay attention to categories in which your country rates as economically strong or weak, as these will help you recommend strategies for economic improvement. You can follow these steps and record your findings in your Interactive Student Notebook: Use your handout to determine how economically free your assigned country is. Four criteria were used to determine each country’s economic freedom. Research each of the sub-categories in your criteria. Does your research align with the rating of your country’s economic freedom? Compose a list of questions based on your research. Do your questions have answers that clarify or complicate your findings? 2020 Teachers' Curriculum Institute

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Be sure to record your sources. Reflect on the research you have gathered to determine the recommendations that you will make regarding the criteria you analyzed. Begin to compose your findings into a strategy to implement your recommendations. Be sure to refer to your supporting sources to strengthen your argument. Present your project to the class. Be sure to clearly state the relevant information about your country, identify the factors that contribute to or detract from the country’s economic freedom, and share your reasoning for why your recommendation will produce positive outcomes for the country’s economic future. By following these steps, you will become more informed about economic freedoms around the globe. You will also better understand the role of government in determining these freedoms. When you are ready, get into your groups and begin investigating the Economic Question.

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Demand and Supply What are demand and supply, and what factors influence them?

Vocabulary Glossary Vocabulary Cards demand law of demand substitute good complementary good supply law of supply revenue elasticity

Introduction

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The demand for Star Wars tickets left many waiting in lines for hours to see the film.

In 1977, a movie was released that changed the film industry—and sent a ripple through the U.S. economy. That film was Star Wars, later retitled Star Wars: Episode IV – A New Hope. Star Wars was the first in a series of movies that would become one of the most successful film franchises in the world. The first movie was such a hit, fans lined up around the block to see it.

Star Wars ran in theaters for 18 months. After its official re-release in 1997, 20 years after the movie initially premiered, the first Star Wars film had earned over 775 million dollars worldwide (1.5 billion in 2017 dollars). Most people did not expect Star Wars to be a box office hit when it was first released. As the film’s director, George Lucas, recalled, “I didn’t think the film was going to be successful.” Neither did 20th Century Fox, the film studio that funded the movie-making process, which did not allocate much monetary support to market the movie. Star Wars’ marketing team was able to advertise the film among comic book and science fiction fans, but did not generate a lot of buzz otherwise. As a result, few theaters wanted to show Star Wars. If you had the opportunity to see Star Wars when it first premiered, having no knowledge of how popular the franchise would become, Level: A

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would you have been particularly interested in the film? Probably not, unless you were a comic book fan or were interested in science fiction. Now assume that after seeing Star Wars in the news, you decided that you wanted to see it. How long would you have been willing to wait in line? After the film’s premiere, some theaters sold out seats for every showing for weeks at a time, and fans waited hours in line for a chance to see it themselves.

Star Wars’ success is more than a story about a box office hit. From an economist’s point of view, it is also an illustration of demand, and of how demand can change. In this lesson, you will learn more about demand and its partner, supply. You will explore how price and other factors influence what consumers demand and what producers are willing to supply.

1. How Do Demand and Price Interact? Most people’s understanding of demand comes from their own experience as consumers. Consumers, after all, are the ones who decide what to buy and how much to spend. Demand, in this everyday sense, is whatever consumers decide they want. But how do consumers —how do we—make those decisions?

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When consumers shop for cell phones, they have to consider two things: if they want a new phone, and if they are able to pay for it.

Consider this scenario. You are shopping for movies online, and you see that Star Wars: Episode IV – A New Hope costs $15. Do you buy it? Would you be more likely to buy it if it were priced at $11? What about if it were priced at $18? If you respond the way economists expect you to, the lower the price, the more likely you would be to buy the movie. This is a key idea in understanding the relationship between demand and price. Demand: What We Are Willing and Able to Buy at Various Prices Anyone who has ever gone shopping knows that making a purchase depends on two things. You have to be willing to buy the item in question, and you have to be able to pay for it. Those two characteristics of consumers—willingness and ability—both matter to economists. You may want the newest cell phone, for example, but if you don’t have $1000, you cannot buy it. You see an older model cell phone priced at $500, but you do not like it enough to spend the money. For you to contribute to the demand for either phone, you have to be both willing and able to buy. What does it mean to contribute to the demand for something? Let’s Level: A

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say that you do, after all, buy an older model cell phone for $500. That one phone, at that one price, is what an economist would call your quantity demanded. Quantity demanded is the amount of a good or service that consumers are willing and able to buy at a specific price. If a different store were to charge $400 for the same model and consumers bought 30 phones, then that amount at that price—30 phones at $400 each—would be the quantity demanded. When each of the quantities demanded at all the various prices at which a good is sold are added together, the result is demand. Demand is the amount of a good or service that consumers are willing and able to buy at all prices in a given period. Demand is expressed in terms of a time frame, such as “per day” or “per week.” To say that consumers bought 14 million iPhones does not, to an economist, convey demand. But 14 million iPhones purchased in one month is demand. In fact, it is enormous demand, and every consumer who bought an iPhone during that period, at any price, contributed to it. Using a Demand Schedule to Determine One Consumer’s Willingness and Ability to Buy Price is obviously important to consumers. How important is it? A simplified model of a market can show us how prices can influence consumers’ buying decisions. Suppose that Tyler is the sole consumer in a market with one product, tacos. Assume that the tacos sold in this market are all exactly alike. This is the ceteris paribus, or other-things-being-equal, assumption. Also assume that price is Tyler’s only consideration. Tyler eats tacos several times a week at a taquería, or taco stand, owned by Jasmine. One day, Jasmine conducts a customer survey to find out how Tyler might react to a price change. The survey asks how many tacos per week Tyler would be willing and able to buy at various prices. The results of Jasmine’s survey are shown in the table in Figure 5.1A. Economists call this kind of table a demand schedule. An individual demand schedule lists the quantities of a good that one person will buy at various prices. Tyler’s demand schedule shows that at a price of $1.00, his quantity demanded is nine tacos. That is, he can be expected to buy nine tacos per week when the price is $1.00. Notice that as the price increases, the quantity of tacos that Tyler is willing and able to buy decreases.

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The data from Tyler’s demand schedule are plotted on the graph in Figure 5.1A. Each pair of variables in the demand schedule is a pair of coordinates marking a point on the graph. The line that is formed by connecting the points is called a demand curve. A demand curve shows the relationship between price and the quantity that buyers are willing and able to buy. As the price changes, the quantity demanded moves up or down along the demand curve. Notice that this demand curve happens to be a straight line. Demand curves can be straight or curved. As you might expect, this demand curve shows that Tyler is able and willing to buy a lot more tacos at $0.50 apiece than at $3.00 apiece. Market Demand: The Sum of All Consumers’ Willingness and Ability to Buy In the real world, of course, Jasmine would need more than one customer to stay in business. Suppose she opens the doors of her taqueria to the general public, a move that gains her three more customers: Amber, Kayla, and Luis. She now needs to consider the market demand for her tacos. Market demand is the sum of all the individual quantities demanded in a market. When economists refer to demand, they are usually talking about market demand.

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Figure 5.1A A demand schedule and graph show how much of something consumers in a market are able and willing to buy at various prices. In this case, the market has just one consumer, Tyler. • When plotted on a graph, the data from Tyler’s demand schedule form a demand curve. • Each point on the curve shows the relationship between price (on the vertical axis) and quantity demanded (on the horizontal axis).

Knowing market demand helps businesses make plans because it tells them how many goods all consumers will buy at various prices. To determine that broader demand, a business might track sales of a product at various prices, or a business owner might conduct a survey. Jasmine again uses a survey to determine the demand for her tacos. A schedule of the data is shown in Figure 5.1B. It shows the sum of the quantities demanded at each price by each of the four consumers. This sum is the market demand for Jasmine’s tacos. The accompanying graph shows the same market demand data. Each point on the curve represents the quantity of tacos demanded at a particular price. As you might expect, there is a clear relationship between price and demand for Jasmine’s tacos. The Law of Demand: As Price Increases, Quantity Demanded Decreases One thing is clear from both of the demand graphs you 2020 Teachers' Curriculum Institute

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just looked at. As the price of tacos increases, the quantity demanded decreases. As the price decreases, the quantity demanded increases. Price and quantity demanded move in opposite directions. This inverse relationship between price and quantity demanded is so strong that economists refer to it as the law of demand . Economist David Henderson calls the law of demand the “most famous law in economics, and the one that economists are most sure of.”

Figure 5.1B Market demand is the sum of the individual quantities demanded in a market. In this case, the market is made up of the four consumers listed on the demand schedule. • When plotted on a graph, the data from the schedule forma demand curve for Jasmine’s tacos. • Point A on the curve represents 30 tacos (7 + 7 + 6 + 10) demanded at $1.50 per taco. At this price, Jasmine can expect to sell 30 tacos a week.

Why do price and quantity demanded move in opposite directions? The answer can be found in three factors that affect consumers’ spending Level: A

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behavior.

The law of diminishing marginal utility. Sometimes a consumer has todecide whether or not to buy something, like a movie at a particular price. Other times, however, as the thinking-at-the-margin principle tells us, consumers are faced with the choice not of whether to buy, but of how much to buy. This raises the question of marginal utility.

If the price of sandals were to rise, consumers might decide they do not need them after all if a cheaper substitute was available. This would cause the quantity of sandals demanded to decrease.

How much utility, or satisfaction, is there in consuming “just one more”? The law of diminishing marginal utility tells us that with most goods and services, the more we have already consumed, the less satisfaction we are likely to get from consuming yet another additional unit. This explains why each helping of food you eat at an all-you-caneat buffet is less enjoyable than the one before. Does this mean that people will not buy ever-larger quantities of a good or service? No, but it does imply that they will do so only if the price is low enough.

The income effect. Because of scarcity, people’s incomes are limited. They have only so much money to spend. If the price of a good 2020 Teachers' Curriculum Institute

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or service increases, they will not be able to continue to buy the same quantity as they did at the original price.

The substitution effect. Sometimes two different goods can satisfy the same want. Such products are called substitute goods. Flip-flops, for example, can satisfy the same want as leather sandals for many people. What happens if the price of sandals increases relative to the price of flip-flops? At some point, people will substitute the cheaper good for the relatively more expensive one. All three factors cause consumers to react in predictable ways to a change in the price of a good or service. As consumers buy more in response to a decrease in price—or less in response to an increase in price—the quantity demanded is said to “move along the demand curve.” Economists call this movement along the curve a change in quantity demanded. Only a change in price causes a change in quantity demanded.

2. What Can Cause Demand to Change? As the law of demand recognizes, price is key when people are deciding what and how much to buy. But other factors can influence demand as well. Suppose, for example, that a street fair was held on the block where Jasmine’s taqueria is located. She might be mobbed with customers. The demand for her tacos would certainly increase. Or, suppose a blizzard brought the city to a halt. If this occurred, Jasmine would have very few customers for a day or two, and the demand for tacos at all prices would decrease. How would these changes in demand be reflected on a graph? Graphing Changes in Demand: Shifting Demand Curves Movement along a demand curve shows how the quantity demanded changes as the price of a good or service changes. But sometimes a factor other than price—such as a spike or a drop in the number of customers—causes an entire demand curve to shift to a new position on the graph. Economists call this shift a change in demand . A change in demand occurs when quantities demanded increase or decrease at all prices.

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Figure 5.2 An increase or decrease in market demand can cause the entire demand curve to shift to the right or the left. The original market demand for Jasmine’s tacos is shown by the blue demand curve labeled D1. The green curves labeled D2 and D3 represent changes in demand. • Follow the dashed lines from Points A and B to the xaxis. Note that the quantity demanded at Point B and every other point on D2 has decreased by 10 tacos. • Do the same for Points A and C. What change in demand do you see between D1 and D3? 2020 Teachers' Curriculum Institute

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The market demand schedule in Figure 5.2 shows the changed demand for tacos. The original market demand schedule for Jasmine’s tacos appears in the middle column. The column to the left shows the decrease in market demand for the week of the blizzard. The column to the right shows the increase for the week of the street fair. Each demand curve on the accompanying graph corresponds to one of the three demand schedules. The demand curve in the middle shows the original market demand for tacos. The curve to the right shows an increase in quantity demanded at every price, and the curve to the left shows a decrease in quantity demanded at every price. Both the decrease and the increase in market demand have caused the entire demand curve to move. When a factor other than price alters demand, economists say the demand curve has shifted. An increase in demand shifts the demand curve to the right, and a decrease in demand shifts it to the left. Demand Shifters: Factors that Cause a Change in Demand Economists have identified several demand shifters that can cause a change in demand for a good or service. We will consider each demand shifter as if it were independent—ceteris paribus. However, everything is interconnected.

Changes in income. Generally, an increase in income increases people’s demand for goods and services, and vice versa. If you like movies, for example, you probably go to more movies when you are working and earning money than when you are not. When the economy is growing and jobs are being created, more people earn more income. The demand for many goods and services increases at all prices. That is, their demand curves shift to the right. The opposite also holds true. In an economic downturn, incomes—and demand—can decrease. The demand curves for many goods and services shift to the left.

Changes in the number of consumers. A change in the number of consumers can cause market demand to shift. You saw this effect in the taco stand scenario, when the street fair brought in more customers and the blizzard prevented customers from coming. In some markets, this effect is seasonal. In a summer resort town, for example, market demand for hotels and restaurants increases when summer brings an influx of consumers. When summer ends and the tourists leave town, demand decreases sharply.

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Changes in consumer tastes and preferences. Consumers do not necessarily buy the same products year after year. Sixty years ago, only a small number of Americans ate sushi, and they did so mainly at Japanese restaurants. Today, sushi is so popular that it is sold in many supermarkets. This change in consumer tastes has caused an increase in demand for sushi. The demand curve for sushi has steadily shifted to the right. Advertising can play a powerful role in shaping consumer preferences. Suppose, for example, that a producer of sunglasses was to launch an advertising campaign with celebrity endorsements. At all price levels, quantity demanded would likely increase. The demand curve would shift to the right.

Changes in consumer expectations. Prices don’t actually have to rise or fall to cause consumers to change their behavior. Consumers may decide to buy or not to buy based on the expectation of a price change. Let’s say you go into a store with the intention of buying a particular video game. You find the game, which is priced at $59.99. A salesperson informs you that this game will go on sale next week for $39.99. You put the video game back. The expectation that the price will soon go down has, for the moment, lessened your demand. Changes in the price of substitute goods. A change in the price of one product in a pair of substitute goods can cause the demand curve for the other good to shift. Take burritos and tacos, for example. If the price of burritos were to increase, the law of demand tells us that people would buy fewer burritos, which would cause movement along the demand curve for burritos. At the same time, assuming that the price of tacos did not change, consumers would tend to buy more tacos, instead of buying burritos. Market demand for tacos would increase, and the demand curve for tacos would shift to the right. Other pairs of substitute goods include fish and chicken, sweatshirts and jackets, and movie tickets and Blu-ray rentals. Changes in the price of complementary goods. A complementary good is a product that is consumed along with some other product. Tennis rackets and tennis balls are complementary goods, as are hamburgers and buns. Demand for one complementary good increases and decreases along with demand for the other. So, for example, if the price of printers were to decrease, the quantity of printers demanded would increase. As a result, demand for the ink cartridges that go with the printers would also increase. Assuming the price of the cartridges remains unchanged, the demand curve for cartridges would shift to the right. 2020 Teachers' Curriculum Institute

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3. How Do Supply and Price Interact? Opposite every consumer in a market exchange is a producer. Producers supply the goods and services that consumers demand. They decide what to supply and how much to produce. How do they make those decisions? Price plays a critical role for producers, just as it does for consumers. Jasmine, for example, might be willing to sell a certain quantity of tacos for $2.00 apiece. But would she be willing to sell the same quantity at $1.00 apiece? Economists can safely predict that her answer would be no. The lower the price, the fewer tacos Jasmine would be willing to sell. This is a key idea in understanding the interaction between supply and price. Supply: What Producers Are Willing and Able to Sell at Various Prices When we look at the supply side of the market, we find that the same concepts and terms that apply to consumers also apply to producers. The same ceteris paribus assumptions apply as well. All tacos are the same—and price, for now, is Jasmine’s only consideration. Level: A

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All other variables that might influence supply, including the cost of ingredients, are held constant. Suppose, then, that a customer wants to buy as many tacos as Jasmine is willing to supply in a week for a big party. However, Jasmine is only willing to supply 300 tacos at $1.00 apiece. Her profit at that price is so low that she is not interested in producing more. At a price of $3.00, however, she is willing to supply 500 tacos to the party giver. Each of these amounts is a quantity supplied. Quantity supplied is the amount of a good or service that producers are willing and able to offer for sale at a specific price. When we add up the quantities that Jasmine and all other taco producers are willing and able to sell at all prices, the result is supply. Supply is the amount of a good or service that producers are willing and able to offer for sale at all prices in a given period. Like demand, supply is always expressed in terms of a specific time period, such as weeks or months. Using a Supply Schedule to Determine One Producer’s Willingness and Ability to Sell A look at Jasmine’s supply schedule can help us understand how price and supply interact. A supply schedule is a table that shows the quantities supplied at different prices in a market. The individual supply schedule in Figure 5.3A shows the quantities that Jasmine will supply at different prices. Notice that as the price increases, the quantity of tacos that Jasmine is willing and able to offer for sale also increases.

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Figure 5.3A A supply schedule and graph show how many producers of a good or service are able and willing to supply at various prices. In this case, the market has just one producer, Jasmine. When plotted on a graph, the data from Jasmine’s supply schedule form a supply curve. • Each point on the supply curve shows the relationship between price (on the vertical axis) and quantity supplied (on the horizontal axis). • At any point below the supply curve, Jasmine’s profit is so low that she has little motivation to increase her production.

The data from Jasmine’s supply schedule are plotted on the accompanying graph. Each pair of variables from the schedule— quantity and price—is a pair of coordinates marking a point on the graph. The line formed by connecting the points is a supply curve. A supply curve shows the relationship between the price and the quantity that producers are willing and able to supply. This supply curve shows that Jasmine will offer many more tacos for sale at a price of $3.00 each than she will at a price of $0.50 each. Market Supply: The Sum of All Producers’ Willingness and Ability to Supply Jasmine’s taqueria has thus far been operating in an imaginary one-producer market. A more realistic scenario would be a market with multiple producers, each one contributing to the market supply of tacos. Market supply is the sum of all the individual quantities supplied. When economists refer to supply, they are usually talking about market supply. Economists studying markets have several methods of determining market supply. One is to keep track of production figures—how many goods each firm in a market is producing. Another is to survey firms to find out their quantities supplied at different prices. Level: A

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Suppose that Jasmine now has two competitors in the taco market: Aleta and Joshua. A survey of these three producers might result in the supply schedule shown in Figure 5.3B. The schedule shows each producer’s individual supply per week and the resulting total market supply.

Figure 5.3B Market supply is the sum of the individual quantities supplied in a market. In this case, the market is made up of the three producers listed on the supply schedule. When plotted on a graph, the data from the schedule form a market supply curve for tacos. • Point A on the curve represents 750 tacos (350 + 125 + 275) supplied at a price of $1.50. That is how many tacos the market is willing and able to supply per week at that price. • As the price increases, the three producers’ profits rise. This increase in profit makes the producers willing to supply more tacos at higher prices.

The accompanying graph shows the same data as a market supply 2020 Teachers' Curriculum Institute

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curve. Each point on the curve represents a quantity of tacos supplied at a given price. As you might expect, the graph shows a clear relationship between price and supply of tacos. The Law of Supply: As Price Increases, Quantity Supplied Increases Jasmine’s supply curve and the market supply curve share an important similarity. In both, the quantity of tacos supplied increases as the price of tacos increases. As the price decreases, the quantity supplied decreases. Price and quantity move in the same direction. Economists refer to this direct relationship between price and quantity as the law of supply . The law of supply holds true as long as all other influences on supply remain constant. Why do price and quantity supplied move in the same direction? Economists cite two main reasons: production decisions by existing producers and market entries and exits. Production decisions by existing producers. In a market-based economy, every producer’s primary goal is to maximize profits. Firms earn profits based partly on revenue, the amount of money received in the course of doing business. Bringing in more revenue is likely to increase profits, so when prices increase, the desire to make a profit leads producers to increase their production of goods. They expect their profits to increase as a result. Likewise, when prices fall, producers are likely to cut production. Market entries and exits. When the price of a good or service increases, new firms may enter a market because they see the potential for profit. For example, a building firm might enter the housing construction market to take advantage of rising home prices. Suppose the firm were to build 20 new homes and offer them for sale at $500,000 each. This would increase the quantity of houses supplied at that price. The reverse can also happen when prices drop. Producers may exit the market, decreasing the quantities supplied at certain prices. The law of supply tells us that producers react in predictable ways to a change in the price of a good or service. As producers supply more at higher prices, and less at lower prices, the quantity supplied is said to “move along the supply curve.” Economists call this movement along the curve a change in quantity supplied . The only factor that causes a change in quantity supplied is price.

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If the price of tacos remains high, new businesses, like this taco truck, may enter the market. This would increase the overall quantity of tacos available to consumers.

4. What Can Cause Supply to Change? As the law of supply recognizes, price is important to producers when they are deciding how much of a good or service to offer for sale. But just as many factors can influence demand, factors other than price can also influence supply. Think about what would happen if Jasmine were to close her taqueria. The market supply of tacos would decrease at all prices. If a new taqueria were to open, the market supply of tacos would increase at all prices. What would these changes in supply look like on a graph? Graphing Changes in Supply: Shifting Supply Curves When the price of a product changes, the quantity supplied moves along the supply curve. But often a variable other than price—such as a change in the number of producers—can cause market supply at all prices to increase or decrease. Economists call this a change in supply . A 2020 Teachers' Curriculum Institute

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change in supply causes the entire supply curve to shift to a new position. The graph in Figure 5.4 illustrates this supply curve shift. The schedule in Figure 5.4 contains market supply data for our imaginary taco market. The original market supply of tacos is shown in the middle column. The decrease and increase in market supply are shown in the columns to the left and right.

Figure 5.4 An increase or decrease in market supply can cause the entire supply curve to shift to the right or the left. The original market supply for tacos is shown by the dark blue supply curve labeled S1. The green curves labeled S2 and S3 represent changes in demand. • Follow the dashed lines from Points A and B to the x-axis. Note that the quantity supplied at Point B and every other point on S2 has decreased by 200 tacos. • Do the same for Points A and C. What change in supply do you see between S1 and S3?

The three supply curves on the graph correspond to the three market supply schedules. The original market supply data were used to plot the supply curve in the middle. The supply curve on the left shows the decrease in quantity supplied at every price, and the supply curve on the right shows the increase in quantity supplied at every price. These changes in supply caused the entire supply curve to move. When this happens—when a factor other than price causes the quantities supplied at every price to change—economists say that the supply curve has shifted. When supply increases, the supply curve shifts to the right. When supply decreases, the supply curve shifts to the left. Level: A

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Supply Shifters: Factors that Cause a Change in Supply Economists point to several factors that can cause a change in supply of a good or service. Six of these supply shifters are listed below. Although we will examine each supply shifter as if it were independent of the rest—ceteris paribus—remember that everything is interconnected.

Changes in the cost of inputs. Any change in the cost of a factor of production—land, labor, or capital—will result in a change in the market supply of a product. Profit is the key to this process. Lower production costs increase profits. Higher profits are an incentive to produce more. Thus, a decrease in production costs causes an increase in supply. The supply curve shifts to the right. In the same way, an increase in production costs causes a decrease in supply. For example, an increase in the price of coltan, a metallic ore used in the manufacture of electronic devices, would cause cell phone production costs to increase. Profits would go down. The quantity of cell phones that producers would be willing and able to supply at all prices would likely decrease. In this case, the supply curve would shift to the left.

Changes in the number of producers. Another factor that affects supply is the number of producers in a market. Producers enter a market when they think there is a profit to be made. This happened with lightweight tablet computers were brought to market. The iPad, introduced by Apple in 2010, was the first tablet to enjoy robust sales. Its success attracted many other producers into the tablet market. The market supply of tablets increased dramatically. Changes in conditions due to natural disasters or international events. Natural disasters such as hurricanes, floods, and wildfires can decrease supply. Consider what would happen to the supply of corn if a sudden cold snap were to wipe out half the Midwest’s corn crop. Supply would decrease—producers of corn would supply fewer goods at every price. International crises such as wars and revolutions can have a similar effect. For example, what if a rebel group were to block the main port of a major copper producing country? Firms producing copper wire and copper pipes would supply smaller quantities at every price.

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Factors as diverse as natural disasters and new technology can cause a shift in supply. A frost, for example, can decrease the supply of corn by destroying much of an area’s crop. In contrast, a technological advance, such as the use of industrial robots to assemble automobiles, can increase supply by improving productivity.

Changes in technology. Technological advances can reduce the amount of labor needed to produce a good, thereby lowering costs and increasing productivity. A prime example of this kind of technology is the robot. Automobile manufacturers today use thousands of robots for spot welding, painting, assembly, and other tasks. This technology allows automakers to produce more vehicles with the same amount of human labor. This, in turn, lowers the cost of production, which leads to 2020 Teachers' Curriculum Institute

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an increase in supply.

Changes in producer expectations. Producers often make supply decisions based on the expectation that prices will rise or fall. For example, what if wheat farmers were offered a lower than average price for their crop? Farmers might take part of their crop off the market and put it into storage. Expecting higher prices in the future, wheat farmers would supply less to the market today. The supply curve for wheat would shift to the left. Expectations that future prices will fall leads to the opposite effect—producers supply more to the market in the short term in an effort to make a profit before prices decrease. Changes in government policy. Governments can directly affect supply in two ways. One is by offering producers a subsidy—a cash payment aimed at helping a producer to continue to operate. The U.S. government, for example, pays large subsidies to farmers. Farm subsidies do not necessarily increase supply, however. Sometimes farmers are paid not to farm their land to keep supply low and prices high. Governments also use excise taxes to reduce the supply of certain goods. An excise tax is a tax on the manufacture or sale of a good. It adds to the production cost of every unit produced, thereby causing supply to decrease.

5. What is Demand Elasticity? What Factors Influence It? You no doubt already have a good idea of what elasticity means in the everyday world—rubber bands and bungee cords come immediately to mind. In the world of economics, elasticity retains this idea of “stretchiness.” Economists define elasticity as the degree to which a quantity demanded or a quantity supplied changes in response to a change in price. The degree of elasticity tells economists how responsive consumers and producers will be to a change in the price of a good or service. Elasticity of Demand: A Measure of Consumer Sensitivity to Price Changes The economist Alfred Marshall first developed the idea that demand is elastic more than a century ago. He introduced the term elasticity to describe the way quantity demanded responds to changes in price. Economists since Marshall have referred to elasticity of demand as a measure of consumers’ sensitivity to a change in Level: A

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price. How sensitive are you to price changes? The answer most likely depends on what you want to buy. If the price of toothpaste were to increase by 50 percent, for example, you would probably buy it anyway. The demand for necessities like toothpaste tends to be inelastic, meaning that it responds slightly or not at all to a change in price. In contrast, if your favorite energy bars were marked up by 50 percent, you might decide to buy something else instead. Your demand in this case would be elastic, or responsive to a change in price. Calculating and Graphing Elasticity of Demand To an economist, the terms elastic and inelastic have precise mathematical definitions. To calculate the degree of elasticity of demand, economists use the following formula: percentage change in quantity demanded demand elasticity =

percentage change in price

If the result of this calculation is greater than 1, demand is said to be elastic. If the result is less than 1, demand is inelastic. In Figure 5.5, you can see how these calculations work out for the toothpaste and energy bar examples you read about previously.

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How sensitive would you be to changes in prices for these goods? Probably not very. Demand for goods that seem essential to daily life (such as salt), or for which there are few good substitutes (such as toothpicks), tends to be relatively inelastic.

Figure 5.5 also illustrates how elasticity can be graphed using a demand curve. The first graph shows a demand curve for toothpaste. A 50 percent increase in the price of toothpaste produces only a 10 percent decrease in the quantity demanded. The result is a demand curve with a steep slope. The quantity of toothpaste demanded moves only slightly along this steep curve when the price increases or decreases. The second graph shows a demand curve for energy bars. Here, a 50 percent increase in price produces an 80 percent decrease in the quantity demanded. The result is demand curve with a flatter slope. The quantity of bars demanded moves much farther along this curve in response to price changes than is the case with toothpaste. Economists use several terms to describe degrees of elasticity. In addition to elastic and inelastic, they speak of perfectly elastic, perfectly inelastic, and unitary elastic. Unitary elastic demand occurs when the percentage change in price exactly equals the percentage change in quantity demanded. The result of the elasticity calculation in such instances is exactly 1. The only way to know for certain whether a demand curve is elastic or 2020 Teachers' Curriculum Institute

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inelastic is to plug the percentages into the formula and do the math. But as a general rule of thumb, the flatter the curve, the more likely it is that demand is elastic. The steeper the curve, the more likely it is that demand is inelastic. Measuring Elasticity of Demand with the Total Revenue Test Knowing how elastic demand is for various goods can help producers price their products at a level that maximizes their revenue. To gauge the impact of prices on their revenue, producers use a business tool known as the total revenue test . To measure the elasticity of demand for toothpaste, for example, a producer using the total revenue test would create a revenue table. Like a market demand schedule, a revenue table lists the possible prices for a given product and the market demand at each price. But it has an additional column for total revenue at each price level. Total revenue is calculated by multiplying the quantity of a good sold by the price of the good. For example, a toothpaste producer who sells 22,000 tubes of toothpaste per week at a price of $2.00 per tube earns a total revenue of $44,000 per week. The revenue table for toothpaste shows that as the price of toothpaste increases, total revenue also increases. This response to price changes tells us that demand for toothpaste in this market is inelastic. Even a large change in price leads to a relatively small change in the quantity demanded. In this case, toothpaste producers can maximize their total revenue by selling fewer units of toothpaste at higher prices. The revenue table for energy bars tells a different story. It shows that as the price of the bars increases, total revenue decreases. The demand for energy bars in this market is very elastic—a small change in price leads to a large change in the quantity demanded. This producer will earn a higher total revenue by selling more energy bars at lower prices. Any producer thinking about changing the price of a product needs to know whether demand for that product is inelastic or elastic. When demand is inelastic, price and total revenue move in the same direction. When demand is elastic, price and total revenue move in opposite directions.

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Granola bars, protein bars, and breakfast bars are all satisfactory substitutes for each other. If the price of one bar goes up, consumers can easily switch to another. Because of the availability of so many substitutes, the demand for any one of these bars is relatively elastic.

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demand more elastic for some goods than for others? The following factors help economists predict the elasticity of demand for a good or service.

Availability of substitutes. Demand for products that have close substitutes tends to be elastic. If the price of a sports drink goes up, for example, many consumers will switch to bottled juice or water. Chocolate, however, has no close substitutes. When its price increases, most consumers continue to buy it. Demand for chocolate is inelastic. Price relative to income. Consumers are more responsive to changes in price when buying “big ticket” items, which eat up more income, than when making minor purchases. If you were considering buying a computer, for example, a price decrease of 20 percent might very well motivate you to buy. Your demand in this case would be elastic. Your demand for an inexpensive item like soap, however, would be inelastic. You might not even notice if its price were to increase or decrease 20 percent. Necessities versus luxuries. When a product is perceived as a necessity, demand for it tends to be highly inelastic. Demand for luxuries, in contrast, is elastic. People will always buy food, a necessity, even if prices increase. Luxuries like fancy watches, on the other hand, are goods we can live without. If their price goes up, we can easily stop buying them. Time needed to adjust to a price change. Elasticity of demand can change over time. When gas prices increased sharply in 2011, many people found it difficult to reduce their gas consumption in response. They still needed gas to drive to work, shop, and get around. Over time, however, people adjusted to the price rise. They formed carpools, began using public transportation, and bought smaller cars that used less fuel. As they did so, the demand for gas gradually became more elastic.

6. What Is Supply Elasticity? What Factors Influence It? Economists apply the principle of elasticity to supply in the same way they apply it to demand. Elasticity of supply is a measure of the sensitivity of producers to a change in price. It tells economists how much a product will change the quantity supplied in response to a change in price. Level: A

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Elasticity of Supply: A Measure of Producers’ Sensitivity to Price Changes The law of supply tells us that quantity supplied moves in the same direction as price. As prices rise, producers are motivated to increase production levels in the hope of making higher profits. Thus, a producer whose supply is elastic will likely respond to an increase in price with an increase in quantity supplied. Ice cream makers, for example, are flexible producers. They can churn out more ice cream fairly easily in response to even a small increase in price. They can also slow production just as quickly if the price of ice cream decreases. The supply of ice cream, in this case, is relatively elastic. Not so for antiques. The supply of genuine antiques is limited, and their numbers do not increase much over time. An antiques dealer cannot simply create more antiques to take advantage of increasing prices. Antiques dealers are not very responsive to changes in price because their supply is inelastic. The supply of bananas may be equally inelastic, but for different reasons. Growers can increase the quantity supplied by expanding their banana plantations. But there will be a lag time between planting new banana trees and harvesting more fruit. Until the new plantations begin to produce, the supply of bananas will remain relatively inelastic. Calculating and Graphing Elasticity of Supply Economists calculate elasticity of supply the same way they do demand, using the following formula: percentage change in quantity supplied supply elasticity =

percentage change in price

If the result is greater than 1, supply is said to be elastic. If the result is less than 1, it is inelastic. If the result is exactly 1—the percentage change in price equals the percentage change in quantity supplied— the result is unitary elastic supply . In Figure 5.6, you can see how these calculations work out for yogurt and bananas.

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Figure 5.6 also illustrates how elasticity of supply can be graphed using a supply curve. The first graph shows a supply curve for bananas. You can see that even a 50 percent rise in the price of bananas yields a relatively small change in the quantity supplied. The result is a supply curve with a steep slope. The quantity of bananas supplied moves only slightly along this steep curve when the price increases or decreases. The second graph shows a supply curve for yogurt. Here a 50 percent change in price causes a relatively large change in the quantity supplied. The result is a supply curve with a flatter slope. The quantity of yogurt supplied moves much farther along this curve in response to price changes than is the case with bananas. As with demand curves, economists classify supply curves according to their degree of elasticity. The only way to know for certain whether a supply curve is elastic or inelastic is to run the numbers. But as a general rule, we can say that the flatter the supply curve on a graph, the more likely it is that supply is elastic. The steeper the curve on a graph, the more likely it is that supply is inelastic. Factors that Influence Elasticity of Supply 2020 Teachers' Curriculum Institute

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some goods elastic and other goods inelastic? Several things can influence the elasticity of supply at different points along the supply chain. The supply chain is the network of people, organizations, and activities involved in supplying goods and services to consumers. The supply chain begins with the delivery of needed inputs to the producer, continues through the production process, and ends with the distribution of the finished product to consumers. Along the path of the supply chain, supply can be affected by any or all of the following factors, the availability of inputs, mobility of inputs, storage capacity, and the time needed to adjust to a price change.

Availability of inputs. Are the inputs needed at the beginning of the supply chain readily available? If the answer is yes, then supply of the product based on those inputs will probably be elastic. Suppliers can offer more or less of the good or service in response to a price change without too much trouble. If key raw materials or other essential inputs are less available, supply is likely to be inelastic. The supply of medical care is a good example. The most important input for good medical care is a trained physician. Medical schools turn out only so many new doctors each year. Producing more in response to a sudden rise in fees for medical services would be difficult. Mobility of inputs. The ease with which inputs and products move through the supply chain also affects elasticity. A new highway, for example, might cut the time needed to ship oats, soybeans, and other inputs from farmers to the manufacturing plants where energy bars are produced. As a result, energy bar producers would be able to respond more quickly to changes in the price of energy bars. Storage capacity. How easy it is to store products as they move through the supply chain has an impact on elasticity as well. Toothpaste, for example, can easily be stored in distribution-center warehouses. Producers can readily hold back or supply more tubes in response to price changes. Bananas, in contrast, are perishable. This makes it harder for producers to adjust their supply as prices change. Time needed to adjust to a price change. The supply of many products is inelastic when the price actually changes, but it may become more elastic with the passage of time. The supply of bananas, for example, may be inelastic in the short run. But given enough time, banana producers will either increase or decrease their future production to adjust to eventual changes in the price of bananas. At this point in your life, you probably do not have to worry about such factors as the mobility of inputs or storage capacity. The key thing to Level: A

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remember now is that the two most important forces in a market economy are demand and supply. Consumers, always looking for a bargain, are generally willing to demand more when the price goes down. On the other hand, producers, always looking to increase profits, are generally willing to supply more when the price goes up. Consumers and producers both look to protect their own best interests. Later on, you will understand how demand interacts with supply to determine what you pay for the goods and services you want most.

Summary Demand and supply are the two forces that make market-based economies work. Demand reflects what consumers are willing and able to purchase at various prices. Supply reflects what producers are willing and able to produce at various prices. Price is related to the quantity of goods that consumers want and producers will provide, although other variables can have a significant influence as well. Economists use elasticity as a tool for measuring how responsive consumers and producers are to price changes. How do demand and price interact? The law of demand states that as the price of a good or service increases, the quantity demanded decreases. As the price decreases, the quantity demanded increases. The inverse relationship of quantity demanded and price can be shown in a demand schedule and graphed as a demand curve. What can cause demand to change? Demand in a market changes when quantities demanded at all prices increase or decrease. On a graph, a change in demand causes the demand curve to shift. Significant demand shifters include income, the number of consumers, and the price of substitutes. How do supply and price interact? The law of supply states that as the price of a good or service increases, the quantity supplied increases. As the price decreases, the quantity supplied decreases. The direct relationship of quantity supplied and price can be shown in a supply schedule and graphed as a supply curve. What can cause supply to change? Supply in a market changes when quantities supplied at all prices increase or decrease. On a graph, a change in supply causes the supply curve to shift. Significant supply shifters include cost of inputs, number of producers, and new technology. 2020 Teachers' Curriculum Institute

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What is demand elasticity? What factors influence it? Demand elasticity is a measure of how responsive consumers are to changes in price. Demand elasticity is influenced by such factors as the availability of substitutes, the product’s price relative to income, whether the product is a necessity or a luxury, and the time needed to adjust to a price change. What is supply elasticity? What factors influence it? Supply elasticity is a measure of how responsive producers are to changes in price. Supply elasticity is influenced by such factors as the availability and mobility of inputs, a producer’s storage capacity, and the time needed to adjust to a price change.

Changes in Supply and Demand You just read about supply and demand, and the forces that can cause changes in the supply and demand curves. You learned that various forces can shift a supply curve. A change in the cost of input can affect the market supply of a product. Lower production costs lead to increased profits. The incentive of high profits leads to increase production, resulting in increased supply. Technological innovations are also key to lower production costs. Changes in producer expectations can alter supply, as producers may change their products or remove them from the market in hopes that it will allow them to make a larger profit. The number of producers within the market can also have an affect on supply. If a product is doing well in a market, more producers are likely to enter that market as there is profit to be made. Various forces can also shift the demand curve. Changes in consumer incomes can increase or decrease demand. Increases in income lead to increased demand for goods and services. A decrease in consumer income can have an opposite effect. Changes in the price of substitute goods can also affect demand, as the demand for a substitute good will increase due to the lower price. Meanwhile, the demand for the other good would decrease. Furthermore, when there are a larger number of consumers in a market for a product, demand increases. When larger quantities of consumers want a particular item, demand increases. But when fewer consumers want a product, the demand decreases.

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Markets, Equilibrium, and Prices How do you know when the price is “right”?

Vocabulary Glossary Vocabulary Cards market equilibrium equilibrium price equilibrium quantity price controls price floor price ceiling rationing black market

Introduction

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The buying and selling of produce at a farmers’ market represents the intersection of demand and supply.

If you were to drive through Nebraska, Iowa, Minnesota, and Illinois, you might see fields and fields of corn farms. You might also see large clouds of steam from ethanol plants. These four states produce the most corn in the United States, and also the most ethanol. Ethanol, which in the United States is made primarily from corn, is a biofuel—a fuel made from recently living organisms or their by-products. Ethanol is in growing demand as a gasoline additive to help meet energy needs. Because of this, corn is also in high demand. How does the rising demand for corn affect consumers? Think about all the foods you eat that are made from corn, such as corn flakes, corn muffins, and tortillas. Soda, candy, and hundreds of other processed foods contain high fructose corn syrup. And then there is popcorn. The corn used for popcorn is different from that used in ethanol, and popcorn producers have to pay farmers more to plant it. Higher prices for corn mean increased prices for these foods at the grocery store.

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Ranchers also pay more for corn, which they use to feed cattle, pigs, and chicken. The higher cost of feeding livestock is then passed on to consumers in the form of higher prices for beef, pork, and chicken. Of course, agricultural markets can be unstable, with swings in supply and demand that lead to rising and falling prices. If ethanol does not prove to be as efficient a fuel as people hope, the demand for corn may slow. If researchers discover a more efficient or cheaper source of ethanol, the demand for corn may slow, impacting corn prices. On the other hand, a drought can significantly reduce corn supply, resulting in much higher prices that can affect ethanol production. There will always be factors affecting the prices of the products you buy. In this lesson, you will learn what these factors are. You will see how supply and demand interact to set prices and how changes in supply and demand can cause prices to change. This lesson will help you understand what “the price is right” really means.

1. What Happens When Demand Meets Supply If you have ever been to a farmers’ market or a flea market, you have probably seen people haggling over a price. You also surely noticed that it took an agreement between a buyer and a seller before a deal was made. If the buyer did not like the price, they might have walked away. If the seller had not wanted to accept the buyer’s offer, no sale was made. You may think of such encounters as simple purchases. But to an economist, they represent the coming together of demand and supply. Market Equilibrium: The Point Where Buyers and Sellers Agree In a market where consumers and producers are completely free to buy and sell goods and services, demand and supply work together to determine prices. This is true whether the market is a local farmers market or a global market. The very interaction of demand and supply drives prices to a point called market equilibrium. At this point of equilibrium, the quantity of a good or service that consumers are willing and able to buy equals the quantity that producers are willing and able to sell. The quantity demanded, in other words, equals the quantity supplied. Market equilibrium can be compared to the point reached by a balance scale when each side holds an object of equal mass. The beam of the 2020 Teachers' Curriculum Institute

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scale is level. It does not tip up or down. The opposing forces balance each other to create stability. Likewise, when a market is in equilibrium, demand and supply are balanced. Both consumers and producers are satisfied. Neither side has any reason to tip the scale. Consider watermelons being sold at a weekly farmers’ market. Suppose that when the season opens, local farmers charge $6.50 per seedless watermelon, hoping to sell 350 melons at this price. You and other customers try to bargain the price down, but the farmers will not budge. Most customers walk away, and the farmers sell only 50 melons. The next week, the farmers bring 300 new melons and reduce the price to $6.00 a melon. The price is still too high for you and many others. The farmers sell 100 melons and have 200 left over.

Two weeks later, the farmers bring 200 fresh melons to the market and reduce the price to $5.00. On this day, all of the 200 melons are sold, and everyone who wanted to buy a melon was able to purchase one. The farmers decide to keep the price at $5.00 and bring 200 melons to market each week. At this price, the quantity of melons demanded by buyers equals the quantity supplied by farmers. The melon market at this farmers’ market has reached equilibrium. What if the farmers were to reduce the price even more? Let’s assume they want to quickly sell 100 melons. They reduce the price to $4.00 a melon. At this price, customers are eager to buy. They demand 300 melons, 200 more than the farmers have to sell. Many people do not get a watermelon because the farmers are sold out. Level: A

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The demand and supply schedule in Figure 6.1 shows the quantity of melons demanded and supplied at each price in the market. When these data are plotted on a graph, the resulting demand and supply curves intersect. This point of intersection is the point at which the market is in equilibrium. At the equilibrium point, the quantity of melons demanded equals the quantity of melons supplied. The price marked by the equilibrium point on a supply and demand graph is known as the equilibrium price. At this price, supply and demand are in balance. This price is also known as the marketclearing price because at this price, the market will be “cleared” of all surpluses and shortages. At the farmers’ market, for example, no customer who wants a melon will go home emptyhanded when melons are sold at the equilibrium price of $5.00. Nor will any farmers go home with leftover melons. The quantity marked by the equilibrium point on the same graph is called the equilibrium quantity. At this quantity, the amount of a good or service supplied by producers balances the quantity demanded by consumers. In this example, both the graph and the schedule show that the equilibrium quantity is 200 melons. Prices Move to Bring Markets into Balance When supply matches demand, consumers and producers both come away satisfied. True, consumers would always be happier to pay less and producers would always be happier to charge more. But in a competitive market, prices are negotiated, not dictated by one side or the other.

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Figure 6.1 A market reaches equilibrium when the quantity demanded by consumers equals the quantity supplied by producers. On the graph, equilibrium is found at the point where the demand and supply curves intersect. • What is the equilibrium price at this point? • What is the equilibrium quantity?

A car purchase often involves intense bargaining over price between buyers and sellers. Here, the car buyer and seller have reached agreement on a price that satisfies them both.

A farmers’ market is a good place to witness the communication that Level: A

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passes between consumers and producers. If a farmer sets prices for a product, such as a watermelon, too high for most shoppers, some consumers will try to drive the price down with hard bargaining. Others will look the goods over in silence and then walk away. On the other hand, if a farmer sets prices too low, early-bird bargain hunters will flock to the stall, sweeping up every melon in sight. The farmer who knows how to read these signals will respond by adjusting the price of melons up or down to match the current demand. Such interaction between consumers and producers will eventually establish the equilibrium price for watermelons in that market. This equilibrium price— the price at which shoppers agree to buy all the melons the farmer agrees to sell—is the “right” price for both parties. What goes on at a farmers’ market is a simplified version of the communication that takes place between all producers and consumers. In a larger market, this kind of negotiation happens more slowly and perhaps less personally than at a local farmers’ market. But the process is the same. Consumers and producers send each other numerous “trial and error” messages. Consider, for example, a new product on the toy market—a helicopter that can be controlled by an app. If the producer of this toy helicopter were to price it at $100, and few consumers were to purchase it, consumers would be sending a message to the producer to reduce the price or be left with helicopters on the shelf. On the other hand, if consumers were to form lines out the door to purchase the toy at that price, they would be sending a message to producers that the price may be too low. The interaction between consumers and producers automatically pushes the market price of a good or service toward the equilibrium price. Market price is the price a willing consumer pays to a willing producer for the sale of a good or service. The process by which markets move to equilibrium is so predictable that economists sometimes refer to markets as being governed by the law of supply and demand. This is a shorthand way of saying that in a competitive free market, the law of supply and the law of demand will jointly push the price of a good or service to a level where the quantity demanded and the quantity supplied are equal. Economist Alfred Marshall, who helped develop modern theories of supply and demand, famously compared supply and demand to the blades of a pair of scissors. It would be impossible to determine, he 2020 Teachers' Curriculum Institute

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wrote, whether it is the top blade or the bottom blade that cuts through a piece of paper. The two blades operate in unison. In the same way, the laws of supply and demand operate together to arrive at equilibrium.

2. What Happens When the Price Isn’t “Right”? Economists think of the equilibrium price as the “right” price because it is the price that producers and consumers can agree on. Sometimes, however, producers set a market price that is above or below the equilibrium price. Economists refer to this state of affairs as disequilibrium. When disequilibrium occurs in a market, the quantity demanded is no longer equal to the quantity supplied. Disequilibrium results in either an economic shortage or a surplus.

When a price is set too high or too low, the result is disequilibrium. The quantity demanded and supplied are no longer in balance. For a juice bar owner, the challenge is to find the price at which the number of drinks supplied equals the number of drinks demanded by customers.

When the Price Is Too Low, Shortages Result Have you ever stood in a long line waiting for the latest video game release? Or have you gone to a theater to see a blockbuster movie only to find the Level: A

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tickets sold out when you get to the counter? Economists call situations like these—in which the quantity demanded at a specific price exceeds the quantity supplied—excess demand. Consumers experience excess demand as a shortage. A shortage occurs when there are too many consumers chasing too few goods. To economists, excess demand is a sign that the price of a good or service is set too low. For example, suppose the owners of a juice bar concoct a new smoothie called Blueberry Blast. They price it at $1.50. Soon, the line of customers waiting to buy the $1.50 smoothie is out the door every day. With these long lines, the owners realize that they have a problem— excess demand. The quantity demanded greatly exceeds the quantity they are willing and able to supply at this price. They may not be able to afford additional staff to accommodate all the customers, or to pay for all the smoothie supplies. The low price results in reduced profits for the owners. The Excess Demand graph in Figure 6.2 illustrates this problem. At $1.50 per smoothie, customers will buy 5,000 drinks per month. The juice bar owners supply only 1,000 smoothies at this price. The result is a shortage for the many customers who want smoothies and are not able to buy them. The juice bar owners could solve their excess demand problem by increasing the price of their smoothies until they have fewer long lines throughout the day. Doing this would bring them closer to the equilibrium price, at which the quantity demanded equals the quantity supplied. When the Price Is Too High, Surpluses Result Have you ever looked through a clearance rack for bargains on clothes? Or have you looked for laptops or cell phones on a website that sells overstocked electronic goods? These marked-down products have something in common. They were all initially offered for sale at prices above what consumers were willing to pay. The result was excess supply, a situation in which the quantity supplied at a specific price exceeds the quantity demanded. Producers experience excess supply as a surplus. A surplus occurs when there are too few consumers willing to pay what producers are asking for their goods.

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Figure 6.2 These graphs show what happens when the price of smoothies is set either above or below the equilibrium price. The result is either excess demand or excess supply. • What happens to supply when the price is set $1.00 above equilibrium? • What happens to demand when the price is set $1.00 below equilibrium?

Suppose that the juice bar owners, in an attempt to solve their excess demand problem, raise the price of a Blueberry Blast to $3.50 per drink. Business slows, and they soon discover that they are not selling enough drinks. The quantity demanded by customers is much less than the quantity the juice bar owners want to supply at this price. The excess supply results in a surplus of blueberry smoothie ingredients. Boxes of fresh blueberries go bad in the refrigerator and blenders stand idle on the counter. The Excess Supply graph in Figure 6.2 shows that at $3.50 per smoothie, the juice bar owners are willing and able to produce 5,000 Level: A

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drinks. But customers buy only 1,000 smoothies, resulting in a surplus. If the owners choose to reduce the price, more customers would be willing and able to buy. The price would then move toward the equilibrium price, at which quantity demanded equals quantity supplied. What price should the juice bar owners set for their Blueberry Blast? Figure 6.2 shows that the “right” price is $2.50. At that price, the quantity of smoothies demanded—3,000—equals the quantity supplied. The Time It Takes to Reach Equilibrium Varies In a free market, surpluses and shortages are usually temporary. When a market is in disequilibrium, the actions of many producers and consumers serve to move the market price toward equilibrium. How long it takes to restore the equilibrium price varies from market to market. Owners of a local juice bar might be able to change their blueberry smoothie prices every month until the price is “right.” In contrast, a national fast-food chain might take much longer to find the “right” price for every item on its menu. Menus, signs, and advertising would need to be changed for all the many restaurant items. Whether prices change quickly or slowly, however, once they move toward equilibrium, shortages and surpluses start to disappear.

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Changing weather patterns can affect the supply of some goods. Events like hurricanes and freezing temperatures have led to the destruction of entire harvests of oranges around the world. This has resulted in a severe drop in the amount of oranges that the United States is able to produce each year.

3. How Do Shifts in Demand or Supply Affect Markets? In our hypothetical markets for watermelons and smoothies, equilibrium was restored by adjusting prices, thereby changing the quantity demanded and the quantity supplied in those markets. On a graph, a change in quantity demanded is shown as a movement from one point to another along the demand curve. Similarly, a change in Level: A

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quantity supplied is shown as a movement from one point to another along the supply curve. When quantity demanded and quantity supplied move to the same point—the intersection of the curves— equilibrium is reached. Suppose, though, that instead of changes in quantity demanded and quantity supplied, a market experiences a change in demand or supply. Such a change would shift the entire demand or supply curve to a new position on the graph. This shift, in turn, would have an effect on market equilibrium. Three Questions to Ask About Demand and Supply Shifts Anything that brings about a shift in the demand curve is a demand shifter. Loss of income, a spike in the population, a new trend—any of these events could shift demand by altering consumer spending patterns. Likewise, anything that shifts the supply curve is a supply shifter. Important supply shifters include changes in the number of producers and changes in the cost of inputs. When an event causes the demand or supply curve to shift, the point of equilibrium changes. To analyze such a change, economists ask these three questions: Does the event affect demand, supply, or both? Does the event shift the demand or supply curve to the right or to the left? What are the new equilibrium price and quantity, and how have they changed as a result of the event? Analyzing the Effect of a Change in Demand on Equilibrium Price One of the most powerful factors that can influence market demand is changing consumer tastes. Consider, for example, what might happen if new medical research were to identify blueberries as a powerful “brain food.” How would this event affect the blueberry smoothie market? Think back to the economists' three questions.

Does the event affect demand, supply, or both? The new research affects the demand for blueberry smoothies. After reading the published report, consumers buy more foods made with blueberries because they think eating blueberries will make them smarter. The research has little or no immediate impact on the supply of such products. Does the event shift the demand or supply curve to the right or to the left? The event shifts the demand curve to the right. In Figure 2020 Teachers' Curriculum Institute

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6.3A, the demand for blueberry smoothies before the research was reported is represented by the initial demand curve, labeled D₁. The demand after the report’s release is shown by the new curve, labeled D₂. The D₂ curve is to the right of the D₁ curve. This shift to the right indicates an increase in demand.

Figure 6.3A The graph shows how a shift in the demand for blueberry smoothies can affect market equilibrium. Here, the shift is caused by new research that calls blueberries “brain food.” • Find the initial equilibrium price and quantity. • Note what happens to both the equilibrium price and the equilibrium quantity when the demand curve shifts to the right. • What are the new equilibrium price and quantity?

What are the new equilibrium price and quantity, and how have they changed as a result of the event? Due to increased demand, the new equilibrium price—found at the intersection of the new demand curve and the supply curve—is $3.00. The new equilibrium quantity is 4,000 smoothies. This is an increase over the initial equilibrium price of $2.50 and equilibrium quantity of 3,000 smoothies. Level: A

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Notice that if the juice bar owners had kept the price of smoothies at $2.50 after demand had increased, a shortage would have occurred. At $2.50, consumers would have demanded 5,000 smoothies, but the producers would have been willing and able to supply only 3,000. Therefore, by raising the price to $3.00, the producers found the “right” price—the equilibrium price, at which the quantity demanded equals the quantity supplied. Analyzing the Effect of a Change in Supply on Equilibrium Prices Among the many variables that can shift market supply are extreme weather conditions, such as hurricanes, floods, and freezing temperatures. Consider how a prolonged summer drought in major blueberry- producing states might affect the market for blueberry smoothies. Suppose the blueberry harvest is half of the average amount. What impact would this have on the market?

Does the event affect demand, supply, or both? The drought and subsequent bad harvest affect supply by driving up the cost of blueberries, one of the raw materials used in the production of blueberry smoothies. As a result of higher input costs, the juice bar owners supply fewer smoothies at every price. The drought has no impact on demand because the higher cost of blueberries does not change the number of smoothies people want to buy. Does the event shift the demand or supply curve to the right or to the left? Because the number of smoothies produced has decreased at every price, the supply curve moves to the left. This is shown on the graph in Figure 6.3B. The new supply curve, labeled S₂, is to the left of the initial supply curve, labeled S₁.

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Figure 6.3B The graph shows how a shift in the supply of blueberry smoothies can affect market equilibrium. In this case, the shift is caused by a drought that damages the blueberry crop. • Find the initial equilibrium price and quantity. • Note what happens to both the equilibrium price and the equilibrium quantity when the supply curve shifts to the left. • What are the new equilibrium price and quantity?

What are the new equilibrium price and quantity, and how have they changed as a result of the event? The new equilibrium price for blueberry smoothies is $3.00. At this price, the new equilibrium quantity is 2,000 smoothies. Before the drought, the equilibrium price was $2.50 and the equilibrium quantity was 3,000 smoothies. The drought has caused the equilibrium price to increase and the equilibrium quantity to decrease. If producers had not raised the price of smoothies, a shortage would have occurred. At $2.50, there would have been demand for 3,000 smoothies, but a supply of only 1,000. In other words, the price was no longer “right” at $2.50. At $3.00, the quantity of smoothies demanded and supplied became equal. Level: A

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Analyzing the Effect of Changes in Both Demand and Supply Finally, consider a scenario in which a combination of events causes changes in the demand and supply of blueberry smoothies at the same time. The first event is the publication of a bestselling book that calls the blueberry “a miracle fruit” that promotes good health. The second event is the announcement by a supermarket chain that it is opening juice bars in most of its local stores. To determine the impact of these two events on the smoothie market, think again of the three questions.

Does the event affect demand, supply, or both? The events are likely to affect both demand and supply. The book, like the research report in the earlier scenario, motivates consumers to buy more blueberry smoothies, thus increasing the quantity demanded at all prices. The juice bars opening in supermarkets cause an increase in the number of producers, thus increasing the quantity of smoothies supplied at all prices. Do the events shift the demand or supply curve to the right or to the left? Because these events cause an increase in both quantity demanded and quantity supplied at all prices, both the demand curve and the supply curve shift to the right. This is shown on the graph in Figure 6.3C. The new demand and supply curves, labeled D₃ and S₃, are to the right of the initial demand and supply curves, labeled S₁ and D₂. This indicates an increase in both demand and supply. What are the new equilibrium price and quantity, and how have they changed as a result of the event? While both demand and supply have increased, demand for smoothies has increased even more than supply has. The graph in Figure 6.3C shows an increase of the equilibrium price from $2.50 to $3.00 and an increase of the equilibrium quantity from 3,000 to 6,000 smoothies. If the juice bar owners had not raised the price by 50¢, a shortage of 2,000 smoothies would have occurred. In the real world, demand and supply are continually shifting in response to events. The impact of such shifts is not always immediately clear. It usually takes time for economists to discern the precise effects of demand and supply shifters on markets. When a product’s demand and supply both increase, economists are safe in predicting that the equilibrium quantity of that product will increase. But economists cannot tell with any certainty how the equilibrium price will change. In our simplified model of a market, the equilibrium price increased. In a real market, the equilibrium price could increase, decrease, or stay the same. 2020 Teachers' Curriculum Institute

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4. What Roles Do Prices Play in a Modern Mixed Economy? Think about the last time you went shopping. What were you shopping for? Clothes? New shoes? A birthday gift for a friend? Whatever it was, you probably found a lot to choose from. Athletic shoes, for example, come in dozens of styles and brand names. In the end, how did you decide what to buy? If you are like most consumers, price was an important component of your decision, perhaps even the deciding factor. As consumers, most of us think of prices simply as indicators of what we have to pay to get what we want. Economists see prices differently. Looking at prices from the point of view of an economist, we find that they perform a number of important roles in a modern mixed economy.

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Figure 6.3C The graph shows how a combined demand and supply shift can affect market equilibrium. In this case, the publication of a book on the health benefits of blueberries causes the shift in demand. The shift in supply is caused by the opening of new juice bars in supermarkets. • What is the initial equilibrium price and quantity? • Note what happens to the market equilibrium when both the demand and supply curves shift to the right. • What is the new equilibrium price and quantity?

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The two cameras shown here are priced very differently. For most people, the camera on their phones are sufficient for many purposes, and therefore people do not have to buy an additional camera. The camera on the bottom, however, has a significantly higher price, which signals that it is equipped for professional-level photography.

Prices Convey Information to Consumers and Producers A primary role of price is to convey information. Both consumers and producers use this information to help make decisions. It may be an overstatement to call prices a “language,” but prices do send a signal. The high price of Manhattan real estate, for example, signals that this particular good is in short supply. The low price of rubber flip-flops sends the opposite signal. As economist Thomas Sowell put it, “Prices are like messengers conveying news.” To consumers, price signals the opportunity cost of a purchase. The opportunity cost of buying any product, remember, is the next best use for the money you spend. You may not think twice about buying something inexpensive, like a pack of shoelaces, because you give up little opportunity with the dollar you spend. On the other hand, before buying a pricey item like a flat-screen television, you would probably shop around, research brands, and seek out the lowest price. When the opportunity cost of buying is high, people tend to think carefully before parting with their money. Prices convey information to producers as well. Prices tell producers Level: A

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what consumers want. Automobile manufacturers, for example, pay attention to which models and features sell at high prices and which need to be marked down in order to attract buyers. Prices are a way for automakers to gauge consumer preferences. Without monitoring prices, carmakers wouldn’t know which models to produce more of and which to cut back on. Producers also use prices to appeal to the consumers they hope will buy their products. A firm that produces backpacks, for example, might offer a stylish model at a low price, targeted to preteens who want one for school. The same firm might produce heavy-duty backpacks for serious adult hikers and offer them at higher prices. In each case, price sends a message about products and their intended markets. Consumers, for their part, are used to interpreting these messages. They know that producers are trying to appeal to a wide range of tastes and budgets. Consumers use price to sort through the resulting variety of goods in the marketplace. Faced with a vast selection of running shoes ranging in price from around $19 to over $200, for example, most consumers will narrow their searches to a limited price range. The choice of how much to spend may, in part, be based on what a person can afford, but it also reflects the consumer’s expectation of what will be available at that price. Prices Create Incentives to Work and Produce As the incentivesmatter principle reminds us, people respond to incentives. In a market-based economy, prices function as an incentive because they represent potential for profit. Rising prices in a market motivate existing firms to produce more, and they encourage new firms to enter the market. Falling prices, in turn, serve as incentives for firms to cut back on production or even to leave a market to look for better opportunities elsewhere. When home prices increase, for example, the change signals construction firms, architects, builders, and tradespeople that there are profits to be made in the housing market. Existing firms build more houses, and new firms get into the act. When prices in the same housing market decrease, the reverse happens. Construction firms build fewer houses. Architects, builders, and tradespeople look for other markets for their talents, such as house renovations and commercial construction. Just as changing prices motivate producers, prices in the form of wages and salaries motivate workers. The opportunity to earn a higher “price” 2020 Teachers' Curriculum Institute

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can inspire people to enter the workforce or seek higher-paying jobs. On the other hand, low wages can act as disincentives for people to seek work. Prices Allow Markets to Respond to Changing Conditions Prices allow markets to adjust quickly when major events such as wars and natural disasters interfere with the production or movement of goods, wreaking havoc on supply. Figure 6.4 shows what happened to gas prices in late summer 2005, when the U.S. Gulf Coast was slammed by two of the most destructive hurricanes in U.S history. The first, Hurricane Katrina, shut down most crude oil production in the Gulf of Mexico and damaged oil refineries from Texas to Florida. Immediately afterward, a government official described the uncertainty facing the oil industry.

They don’t know how many platforms are down, how many refineries are down, and how long it’ll take to get the power back on. It depends on how much damage, particularly hidden damage . . . some of the undersea pipeline damage can be hard to detect. — Michael Burdette, USA TODAY, Aug. 29, 2005 Four weeks later, just as the industry was starting to recover, Hurricane Rita struck, causing additional disruptions to the oil supply. The two hurricanes brought a halt to almost 30 percent of the U.S. oil refinery capacity. For the next few weeks, gas prices fluctuated, sometimes wildly, as oil companies struggled to bring the quantity of gas demanded in line with what refiners were able to supply. One newspaper reported, “Confused drivers in Georgia saw prices that had climbed as high as $5 a gallon suddenly drop back to $3 in the span of 24 hours.” Fluctuating prices frustrated consumers, but they allowed the market to adjust to the disruption in supply caused by the hurricanes. By early November 2005, the industry had largely recovered, with only 5 percent of oil-refining capacity still disabled. The retail price of gasoline that month averaged $2.30 per gallon. A month later, the average price had dropped to $2.23 per gallon, lower than it had been before Hurricane Katrina. This new, low equilibrium price reflected the fact that in addition to the increase in supply as U.S. facilities went back online, refiners throughout the world had rushed fuel to the United States in the months after the hurricanes. As the supply of gasoline increased, prices at the pump went down. Level: A

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Figure 6.4 In August 2005, Hurricane Katrina slammed into the Gulf Coast, destroying offshore oil rigs and damaging oil refineries. The next month, Hurricane Rita struck. Combined, the hurricanes disrupted almost 30 percent of the U.S. oil refinery capacity. The line graph shows how gas prices fluctuated as the market adjusted to these changing conditions.

By throwing the gasoline market into disequilibrium, Hurricanes Katrina and Rita illustrated the key role that prices play in correcting both shortages and surpluses. Prices give markets the flexibility they need to reach equilibrium even under changing conditions. Prices Allocate Scarce Resources Efficiently Perhaps the most important role of price in a market-based economy is to guide resources to their most efficient uses. Consider, for example, the market for dairy products, such as yogurt, ice cream, and cheese. The firms whose dairy products are in greatest demand will buy the most milk in order to make products to meet that demand. Guided by prices that communicate what consumers want, dairy producers automatically allocate milk—a scarce resource used to make many different products — to its most valued use. Or consider the earlier example of car manufacturers who use prices to decide which models to produce and in what quantities. These production decisions are, at bottom, decisions about how best to use limited resources. As Thomas Sowell explained,

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features rather than another, producers automatically produce more of what earns a profit and less of what is losing money. That amounts to producing what the consumers want and stopping the production of what they don’t want. Although the producers are only looking out for themselves and their companies’ bottom line, nevertheless from the standpoint of the economy as a whole the society is using its scarce resources more efficiently because decisions are guided by prices. — Thomas Sowell, Basic Economics, 2007

5. How Does Government Intervention Affect Markets? On the whole, when prices are allowed to freely rise and fall to their equilibrium levels, they do an effective job of allocating scarce resources to their best uses. On occasion, however, governments intervene in the market in an attempt to influence prices. They do this by placing limits on how high or low certain prices may be. These limits are called price controls. Why Governments Intervene in Markets Level: A

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impose price controls is, as the economist Henry Hazlitt reminds us, nothing new.

The record of price controls goes as far back as human history. They were imposed by the Pharaohs of ancient Egypt. They were decreed by Hammurabi, king of Babylon, in the eighteenth century B.C. They were tried in ancient Athens. — Henry Hazlitt, The Wisdom of Henry Hazlitt, 1993 In modern economies, governments usually impose price controls when they are persuaded that supply and demand will result in prices that are unfairly high for consumers or unfairly low for producers. For example, in the 1970s the U.S. government imposed price controls on gasoline in response to reduced shipments of foreign oil due to crises in the Middle East. This action was taken to protect consumers from price swings. The government has also imposed price controls during wars in attempts to ensure that goods are distributed fairly during periods of shortage. Governments can control prices in two ways: by setting price floors or price ceilings. Both methods affect supply and demand. Price Floors Lead to Excess Supply When a government wants to keep prices from going too low, it sets a price floor. A price floor is a minimum price consumers are required to pay for a good or service. A price at or above a price floor is legal, while a price below the price floor is illegal. Price floors are meant to push prices up, ensuring that producers receive a benefit for providing a good or service. Pressure to impose price floors usually arises when producers feel the market isn’t providing them with adequate income. Suppose, for example, that the equilibrium price of wheat were to fall so low that wheat farmers were struggling to survive. The government could intervene to establish a price floor for wheat. The minimum wage is another type of price floor. The minimum wage is a government-imposed legal floor on the hourly wage rate, which is the price the market pays for labor. The rationale for the minimum wage is that in markets where workers outnumber jobs, supply and demand would drive the equilibrium wage so low that many workers would be earning too little to live decently. While price floors may benefit some people, the larger effect of a price 2020 Teachers' Curriculum Institute

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floor is excess supply. To see why, consider the impact of an increase in the minimum wage on both workers and employers. As the minimum wage rises, more people apply for minimum wage jobs. The result is an increase in the supply of job seekers. At the same time, employers reduce the number of minimum wage workers they hire in an effort to keep their wage costs from rising. The result is a decrease in demand for workers. Figure 6.5A illustrates the effect of this combined increase in supply and decrease in demand. For example, at the equilibrium wage rate of $5.00 per hour, the quantity of workers demanded—3 million—equals the quantity supplied. At the minimum wage of $6.00 per hour, however, 4 million workers are supplied—that is, willing and able to work—but only 2 million workers are demanded—that is, hired. This leaves a surplus of 2 million unemployed people. A price floor above the equilibrium price of wheat would have the same effect. Farmers would produce more wheat to sell, but buyers would buy less, resulting in a surplus of wheat.

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Figure 6.5A A price floor is a minimum price set by the government on a good or service. Minimum wage is an example of a price floor. The graph shows how setting minimum wage above the equilibrium wage affects the job market. • How does the price floor in the graph affect the quantity of workers supplied? The quantity demanded? • Is the result of a shortage or a surplus of workers?

Price Ceilings Lead to Excess Demand When a government wants to keep prices from going too high, it sets a price ceiling. A price ceiling is a maximum price consumers may be required to pay for a good or service. A price at or below a price ceiling is legal. A price above the ceiling is not legal. Governments impose price ceilings to enable consumers to buy essential goods or services they wouldn’t be able to afford at the equilibrium price. Price ceilings are usually established in response to a crisis, such as war, natural disaster, or widespread crop failure. Such supply-shifting events can lead to price increases that may cause a financial burden for a great many people while enriching a select few. The best-known form of price ceilings in the United States today is rent control. Rent control regulations make it illegal to charge more than a 2020 Teachers' Curriculum Institute

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specified monthly amount for rental housing. In New York City, rent control was introduced during World War II to protect poor families. Over time these regulations have been eased. By 2014, only 27,000 apartments in New York City were rentcontrolled, compared to 2 million apartments during the 1950s. Figure 6.5B illustrates the effect of rent control on the rental housing market in a typical city. Imposing a rent ceiling that is below the equilibrium rent leads to excess demand. The artificially low rents attract young people eager to leave home and live independently or retirees hoping to reduce their expenses—in short, anyone who likes a bargain— into the rental market.

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Figure 6.5B A price ceiling is a maximum price set by the government on a good or service. Rent control laws are an example of price ceilings. The graph shows how establishing a rent ceiling below the equilibrium rent affects the apartment market. • How does the price ceiling in the graph affect the quantity of apartments demanded? The quantity supplied? • Is the result a shortage or a surplus of apartments?

At the same time, the supply of apartments in the market decreases as landlords who are unwilling to rent at such low prices seek other ways to use their properties. Some, for example, might decide to convert their apartments to condominiums to sell. Moreover, fewer potential landlords enter the rental market because of the difficulty of making a profit under rent control laws. The result is excess demand and a shortage of apartments. Dealing with Excess Supply and Demand: Rationing and Black Markets Price controls lead to surpluses and shortages because they 2020 Teachers' Curriculum Institute

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prevent markets from reaching a market-clearing price. The excess supply and demand that arise must be addressed outside the market. This happens in various ways.

Rationing became a way of life for Americans during World War II. Ration books filled with stamps like those shown here were issued to each household. Rationed items could not be purchased without these stamps. Most people accepted rationing as a necessary part of the war effort. Nonetheless, a black market soon sprang up to provide goods in high demand to customers who had more cash than stamps.

In the case of an agricultural surplus that results from price floors, the government may limit supply by restricting how much farmers are allowed to grow. Or the government may buy the crop surplus at the price floor to store for later use or to give to a developing country as foreign aid. Such aid often has the effect of undercutting farmers in countries that cannot compete with cheap American surplus grain. When shortages occur, the government may impose rationing. Rationing is the controlled distribution of a limited supply of a good or service. For example, during the 1979 oil crisis, price ceilings on gasoline contributed to a severe gas shortage, so the government instituted a rationing system based on license plate numbers to cope Level: A

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with the shortage. During World War II, the government rationed tires, gasoline, sugar, and other goods that were in short supply because they were being used for the war effort. Rationing can be a costly means of allocating scarce goods. A giant bureaucracy, the Office of Price Administration (OPA), had to be set up during World War II to enforce the rationing regulations. Thousands of rationing boards were created, operated by 60,000 employees and 200,000 volunteers. Shortages can also give rise to black markets. A black market is an illegal market in which goods are traded at prices or in quantities higher than those set by law. There was a thriving black market during World War II for meat, sugar, and gasoline, among other products. Some people bought and sold meat through bootleg suppliers. People also made counterfeit ration coupons. In one month alone in 1944, the OPA counted 3 million counterfeit coupons. Why Ending Price Controls Is Difficult At this point you might be wondering why if price controls can be so harmful to markets, the government doesn’t just get rid of them. The answer to this question has more to do with politics than economics. The political pressure on elected officials to intervene in the market when prices rise and fall rapidly can be intense. And although price controls are inefficient, many people believe that they further the goal of economic equity in such situations.

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The minimum wage is a price floor set by the government on the hourly wage rate for labor. The minimum wage is intended to benefit low-wage workers, but critics of the minimum wage claim it may not always do so.

Moreover, some people—farmers, people who live in rent-controlled apartments, workers who earn minimum wage—clearly benefit from price controls. Labor unions also support minimum wage laws because such laws are believed to push all wages upward. The combined voices —and votes—of those who support price controls are enough to make most politicians reluctant to repeal them. Most economists, as you would expect, take a dim view of price controls. When a government tries to set prices, economists warn that it is likely in order to set them too high or too low, which inevitably results in shortages or surpluses. Markets, economists claim, when left alone, will naturally gravitate to the “right” price. This takes us back to the question we started with, How do you know when the price is “right”? The simple answer is that the price is right when the market reaches equilibrium. The process of reaching equilibrium, however, is anything but simple. It involves the individual decisions of countless producers and millions of consumers just like you. Later on, you will learn more about how markets are organized and what happens when they work less perfectly than the model of supply and demand suggests they should.

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In a free market, demand and supply automatically move prices to equilibrium, the point at which quantity demanded equals quantity supplied. What happens when demand meets supply? Demand and supply interact to drive prices for goods and services to the equilibrium level. On a graph, this equilibrium point is found at the intersection of the demand and supply curves. The equilibrium price, otherwise known as the market-clearing price, may be thought of as the “right” price. What happens when the price isn’t “right”? Disequilibrium occurs when prices are set above or below the equilibrium price. When prices are too low, excess demand leads to shortages. When prices are too high, excess supply leads to surpluses. How do shifts in supply or demand affect markets? Many kinds of events can cause demand and supply curves to shift to the right or left. Markets adjust to these differing conditions by seeking a new equilibrium point. What role do prices play in a modern mixed economy? Prices convey information to consumers and producers as to what to buy and produce. Prices motivate workers and firms to enter markets, and they help markets respond to changing conditions. They guide resources to their most efficient uses. How does government intervention affect markets? Governments sometimes implement price controls when prices are considered unfairly high for consumers or unfairly low for producers. Price floors, such as minimum wage laws, prevent prices from going too low, but lead to excess supply. Price ceilings, such as rent control laws, prevent prices from going too high, but lead to shortages.

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Market Structures and Market Failures What happens when markets do not work perfectly?

Vocabulary Glossary Vocabulary Cards market structure perfect competition monopoly oligopoly monopolistic competition market failure externality public goods

Introduction

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Prices and options in a market may depend upon how much competition companies face. Companies that sell phones or computers may face little competition, so they can charge more.

If you have internet at home, at some point in the past your family may have thought about changing their service provider. Perhaps they wanted a higher speed internet that the current provider did not offer, or maybe they wanted to switch to a cheaper plan. Or, perhaps they were annoyed because the provider had raised its rates or altered other terms of the contract. But changing companies might have meant breaking your family’s contract and paying a stiff penalty. So, most likely, they swallowed their frustration and did nothing. Sound familiar? If so, you are not alone. Many different industries have contracts like those of internet service providers. As Bob Sullivan, an investigative reporter specializing in technology and business, has Level: A

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observed, millions of Americans have found themselves stuck in these kinds of “jails” with no easy way out. Sullivan described one such “cell phone jail” in his book Gotcha Capitalism (2007), saying,

You don’t act like a rational consumer in a normal, functioning market economy. You don’t go buy the new phone, or get the cheap new plan. You don’t reward the more efficient company with your business. You can’t. You’re in jail. Imagine if you couldn’t switch coffee shops or grocery stores without paying hundreds of dollars in penalties. Preposterous? No—not in the world of cell phones. What is going on here? How could cell phone or internet companies operate differently from, say, coffee shops or grocery stores or car dealerships? Many companies, including internet providers, use contracts to make up for the money they lose when you stop doing business with them. It is an incentive to keep you from changing companies. And because most internet service providers include early termination fees in their contracts, it becomes difficult to avoid fees and penalties when you are searching for the best deal. What about the freewheeling competition that is the hallmark of a market economy? What about the laws of supply and demand? Well, the truth is that even in a free market economy, not all industries and markets are equally competitive, and when they are not equal, it is usually the consumer who suffers. In this lesson, you will read about various types of markets and how and why they differ. You will also learn about the effects of imperfect and inefficient markets on our economy and society.

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Internet service providers and clothing manufacturers operate in distinctly different markets. Internet service providers offer consumers few choices and require binding contracts. In contrast, clothing companies give shoppers many choices with no strings attached.

1. What Is Perfect Competition, and Why Do Economists Like It So Much? Fortunately, most businesses are more consumer friendly than cell phone or internet companies. Take T-shirt producers, for example, if you go shopping for a T-shirt, you will find hundreds of colors, styles, and designs to choose from in a wide range of prices. The T-shirt industry is very competitive, with many different producers. It is apparent that internet service providers and T-shirt producers operate in different markets with different levels of competition. What accounts for these differences? The Characteristics That Define Market Structure An economist would answer those questions by pointing out that the T-shirt and internet service industries have different market structures. Market structure refers to the organization of a market based mainly on the degree of competition among producers. Economists define market structure according to the following four main characteristics. Level: A

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Number of producers. The number of producers in a market determines the level of competition. Markets with many producers are more competitive than markets with few producers. Similarity of products. The degree to which products in a market are similar also affects competition. The more similar the products are, the greater the competition among their producers. Ease of entry. Markets differ in their ease of entry, which is a measure of how easy it is to start a new business and begin competing with established businesses. Markets that are easy to enter, with few restrictions, have more producers and are thus more competitive. Control over prices. Markets also differ in the degree to which producers can control prices. The ability to influence prices—usually by increasing or decreasing the supply of goods—is known as market power. The more competitive the market, the less market power any one producer will have. Based on these characteristics, economists have identified four basic market structures: perfect competition, monopoly, oligopoly, and monopolistic competition. These structures are shown on a spectrum, from most competitive to least competitive. As you read, keep in mind that these four models are not always easy to identify in the actual economy. In some cases, a market will have mixed features, making it hard to tell how competitive it is. Perfect Competition: Many Producers, Identical Products The most competitive market structure is perfect competition. In a perfectly competitive market, a large number of firms produce essentially the same product. All goods are sold at their equilibrium price, or the price set by the market when quantity supplied and quantity demanded are in balance. Economists consider perfect competition to be the most efficient market structure in terms of allocating resources to those who value them most. Although many markets are highly competitive, perfect competition is relatively rare. It exists mainly among producers of agricultural products, such as wheat, corn, and tomatoes. Other examples of perfectly competitive markets include commercial fishing and the wood pulp and paper industry. Perfect competition has four main characteristics.

Many producers and consumers. Perfectly competitive markets have many producers and consumers. Having a large number of 2020 Teachers' Curriculum Institute

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participants in a market helps promote competition.

Identical products. Products in perfectly competitive markets are virtually identical. As a result, consumers do not distinguish among the products of different producers. A product that is exactly the same no matter who produces it is called a commodity. Examples include grains, cotton, sugar, and crude oil. Easy entry into the market. In a perfectly competitive market, producers face few restrictions in entering the market. Ease of entry ensures that existing producers will face competition from new firms and that a single producer will not dominate the market. No control over prices. Under conditions of perfect competition, producers have no market power. They cannot influence prices because there are too many other producers offering the same product. Instead, the market forces of supply and demand determine the price of goods. Producers are said to be price takers because they must accept, or take, the market price for their product. In addition to these characteristics, one other feature distinguishes highly competitive markets: easy access to information about products and prices. A person shopping for a car, for example, can easily find out the range of models, features, and prices available. Such information is readily accessible at car dealerships, in published reports, and on the internet. Information gathering involves tradeoffs, however. Consumers must balance the time and expense of gathering such information with the money saved by finding a good deal. Economists refer to the costs of shopping around for the best product at the best price as transaction costs. The internet has helped reduce transaction costs by making product and price information more readily available. Instead of driving to various stores or making multiple phone calls, consumers can often make price comparisons over the internet with less time and effort. A Competition Case Study: The Onion Business To get a better idea of how perfect competition works, consider the market for onions. To begin with, the onion market has many producers—there are about 500 growers of commercial onions in the United States. They all offer the same basic commodity. Onions from one farm are pretty much the same as onions from any other farm. Furthermore, no farm produces enough onions to dominate the market and achieve market power. Farmers must be price takers and accept Level: A

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the market price for their onions. If they were to charge more than the market price, their buyers—markets that distribute onions—would simply buy onions from some other producer.

Onion farming can be a difficult job. However, because there are many onion farms, and the product is relatively uniform, nearly anyone can enter into the market.

Onion production also offers relative ease of entry. Anyone who wants to become an onion farmer can enter the market, assuming that they have the resources. Even a farmer with only a few acres can sell onions to a local market. Thus, onion production satisfies the four criteria of 2020 Teachers' Curriculum Institute

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perfect competition. Barriers to Entry Can Limit Competition Our look at onion farming hints at some of the obstacles that can restrict access to a market and limit competition. Such obstacles are known as barriers to entry. One possible barrier is start-up costs, or the initial expense of launching a business. It is much less expensive, for example, to open a bicycle repair shop than it is to open a bicycle factory. An entrepreneur with little financial capital might find it difficult to get into bicycle manufacturing because of the high cost of building a factory. The mining industry offers an example of another barrier to entry: control of resources. If existing mining companies already control the best deposits of iron, copper, or other minerals, it will be hard for new firms to enter the market. Technology can pose yet another barrier. Some industries are more technology driven than others. The need for specialized technology or training may make it difficult to enter these markets. The computer industry is one example. Not only does the manufacturing of computers require advanced technology, it also requires specialized knowledge that can be obtained only through years of education. These factors may act as a barrier, keeping new firms out of the computer market. The Benefits of Perfect Competition As the name suggests, perfect competition is rare in its purest form. Because it is the most efficient market structure, economists consider perfect competition to be the benchmark, or standard, for evaluating all markets. That said, many markets are competitive enough to be “nearly perfect.” Such nearly perfect markets are beneficial in two ways. First, they force producers to be as efficient as possible. When producers can sell only at the equilibrium price, the only way to maximize profits is by allocating resources to their most valued use and by keeping production costs as low as possible. Second, because perfect competition is efficient, consumers do not pay more for a product than it is worth. The equilibrium price of a product in a perfectly competitive market accurately reflects the value the market places on the productive resources—land, labor, and capital—that have gone into it. Economists Robert Heilbroner and Lester Thurow summed up the benefits of perfect competition:

In a purely competitive market, the consumer is king. Indeed the rationale of such a market is often described as Level: A

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consumer sovereignty. The term means two things. First, in a pure competitive market the consumer determines the allocation of resources by virtue of his or her demand—the public calls the tune to which the businessman dances. Second, the consumer enjoys goods that are produced as abundantly and sold as cheaply as possible. In such a market, each firm is producing the goods the consumer wants, in the largest quantity and at the lowest cost possible. —Robert Heilbroner and Lester Thurow, Economics Explained: Everything You Need to Know About How the Economy Works and Where It’s Going , 1998

2. What Is a Monopoly, and Why Are Some Monopolies Legal? Most markets are not perfectly competitive. Because these markets do not allocate goods and services in the most efficient way, as in perfect competition, they are examples of what economists call imperfect competition. Economists define imperfect competition as any market structure in which producers have some control over the price of their products. In other words, those producers have market power. The most extreme version of imperfect competition—and the opposite of perfect competition—is monopoly. Monopoly: One Producer, A Unique Product A monopoly is a market or an industry consisting of a single producer of a product that has no close substitutes. The term monopoly comes from a combination of the Greek words mono, meaning “alone,” and polein , meaning “to sell.” Literally, then, a monopoly is the only seller of something. Monopolies share four main characteristics.

One producer. There is no competition in a monopoly. A single producer or firm controls the industry or market. An economist might say that the monopolistic firm is the industry. Unique product. A monopoly provides a unique product with no good substitutes. No other producers provide similar goods or services. High barriers to entry. Monopolies can exist because of high barriers 2020 Teachers' Curriculum Institute

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to entry that limit or prevent other producers from entering the market.

Substantial control over prices. Monopolistic firms usually have great market power because they have complete control over the supply of a good or service. They can set a price for a product without fear of being undercut by competitors. Unlike competitive firms, monopolistic businesses are price setters rather than price takers.

Like perfect competition, pure monopoly is relatively rare in today’s economy. Monopolies may form and survive for a time, but they often break down in the face of competition or government regulation. In the late 1800s, however, a number of monopolies arose in the United States. Some took the form of one firm that controlled the market for a unique product. Others took the form of trusts, or combinations of firms, that worked together to eliminate competition and control prices. One of the most famous, and feared, monopolies was John D. Rockefeller’s Standard Oil Company. Rockefeller built his monopoly by buying out or bankrupting his competitors until he controlled about 90 percent of U.S. oil sales. Viewing monopolies as harmful to the public interest, Congress enacted antitrust laws to limit their formation. In 1911, the federal government took Standard Oil to court for antitrust violations and broke up its oil monopoly. Figure 7.2 shows the results of that famous trustbusting case. Level: A

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Three Types of Legal Monopolies The government still seeks to prevent the formation of most monopolies. However, it does allow certain kinds of monopolies to exist under particular circumstances. These legal monopolies fall into three broad categories: resource monopolies, government-created monopolies, and natural monopolies.

Resource monopolies. Resource monopolies exist when a single producer owns or controls a key natural resource. Other firms cannot enter the market because they do not have access to the resource. For example, if a firm owns the only stone quarry in a town, it may be able to monopolize the local market for building stone. Resource monopolies are rare, however, because the economy is large and supplies of resources are not usually controlled by one owner. Government-created monopolies. Government-created monopolies are formed when the government grants a single firm or individual the exclusive right to provide a good or service. The government does this when it considers such monopolies to be in the public interest. Government-created monopolies may be formed in three ways.

Figure 7.2 The antitrust action against Standard Oil in 1911 broke up the oil monopoly. This map shows how the oil trust was divided into smaller, competing companies, nicknamed Baby Standards. Each new company took over Standard Oil operations in its assigned region of the United States.

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Grand Canyon Lodges in the Grand Canyon National Park is a public franchise. Its contract with the government gives it a monopoly on lodging, dining, transportation, and other amenities in the park.

Patents and copyrights. These legal grants are designed to protect and promote intellectual capital. They give inventors or creators the right to control the production, sale, and distribution of their work, thus creating a temporary monopoly over that work. For example, a patent issued to a pharmaceutical company gives that company the sole right to produce and sell a particular drug for a period of 20 years. Such patents encourage investment in research and development. In the same way, a copyright grants exclusive rights to an artist, writer, or composer to control a creative work, such as a painting, a novel, or a song, for a period of time. Public franchises. A public franchise is a contract issued by a government entity that gives a firm the sole right to provide a good or service in a certain area. For example, the National Park Service issues public franchises to companies to provide food, lodging, and other services in national parks. School districts may issue public franchises to snack food companies to place their vending machines in public schools. In each case, a single firm has a monopoly in that particular market. Licenses. A license is a legal permit to operate a business or enter a market. In some cases, licenses can create monopolies. For example, a state might grant a license to one company to conduct all vehicle emissions tests in a particular town. Or a city might license a parking lot company to provide all the public parking in the city. Licenses Level: A

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ensure that certain goods and services are provided in an efficient and regulated way.

Natural monopolies. The third type of monopoly is a natural monopoly. This arises when a single firm can supply a good or service more efficiently and at a lower cost than two or more competing firms can. For example, most utility industries are natural monopolies. They provide gas, water, and electricity, as well as cable TV services, to businesses and households. Because natural monopolies are efficient, governments tend to view them as beneficial. A natural monopoly occurs when a producer can take advantage of economies of scale to dominate the market. The term economies of scale refers to the greater efficiency and cost savings that result from increased production. A firm that achieves economies of scale lowers its cost per unit of production by increasing its output and spreading fixed costs over a larger quantity of goods. You can see how economies of scale work by looking at the cost of supplying water to a new subdivision of 50 homes. Suppose it costs a water company $100,000 to build a network of pipes that will bring water to the subdivision. In addition, installing a water meter at each home costs $1,000. The total cost of supplying water to the first home is $100,000, plus $1,000 for a meter, or $101,000 total. Now, look at the cost per home as the number of homes increases. A water meter for the second home costs $1,000, bringing the total cost for two homes to $102,000, or $51,000 per home. A water meter for the third home costs another $1,000, bringing the total cost for three homes to $103,000, or $34,333 per home. By the time the water company gets to the 50th home, its total cost is $150,000—$100,000 for pipes and $50,000 for 50 meters. The cost per home has decreased to $3,000.

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Bill Gates, the chairman and cofounder of Microsoft, testifies at his company’s antitrust trial in August 1998. The trial judge found Microsoft guilty of engaging in monopolistic practices.

What would happen if two companies were to compete to bring water to the subdivision? Each company would have to build its own pipes. The fixed costs of bringing water to the subdivision would essentially double, but the number of homes served would stay the same. As a result, the economies of scale would be substantially reduced. For that reason, it makes sense for the government to allow water companies, like other utilities, to do business as natural monopolies. A Monopoly Case Study: Microsoft Corporation Our government permits certain monopolies that are judged to be in the public interest to exist. In most other circumstances, monopoly is illegal. As in the Standard Oil Company case, the government may take action to break up a monopoly. Consider the case of Microsoft, the giant computer software firm. In the 1980s, Microsoft received a copyright for its computer operating system known as Windows. Microsoft then made deals with computer Level: A

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makers to sell machines with Windows already installed on them. In this way, Microsoft gained control of about 90 percent of the market for operating systems. Microsoft’s monopoly power allowed it to charge more for Windows than it might have in a more competitive market. Microsoft also used its market power to drive potential competitors out of the market. In 1994, a software company called Netscape began selling a new computer application known as a web browser to computer users. A web browser enables computer users to find and view internet sites from around the world. Microsoft effectively drove Netscape out of business by bundling its own version of a browser, Internet Explorer, into its Windows operating system. As part of Windows, Internet Explorer came already installed on most new computers, severely reducing the market for browsers from Netscape or any other software company. In late 1997, the U.S. Department of Justice accused Microsoft of trying to stifle competition by expanding its monopoly power into the internet market. In 1998, Justice Department lawyers charged Microsoft with antitrust violations and took the company to court. In its defense, Microsoft argued that it had merely added new features to its operating system. It claimed that the integration of its web browser was a natural and logical step in efforts to improve its products and satisfy its customers. In November 1999, the trial judge found that Microsoft had violated antitrust laws. He ordered the company to be broken into two separate businesses: one that sold the Windows operating system and another that sold applications software. Microsoft appealed the decision to a higher court, which overturned the breakup order but upheld the antitrust verdict. In 2002, Microsoft settled its case with the government by agreeing to change the way it dealt with other software firms. The company’s troubles did not end there, however. It was later hit by several private antitrust suits and was fined in Europe for anticompetitive actions. Consequences of Monopoly for Consumers The government’s case against Microsoft focused mainly on the company’s aggressive efforts to drive other firms out of the market. But the case also underscored the negative effects of monopoly for consumers. Because a monopolistic firm has considerable market power, it can set prices without fear of lower-priced competition from other firms. As a result, consumers may be forced to pay more for a good or service provided by a monopoly than they would in a competitive market. 2020 Teachers' Curriculum Institute

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Furthermore, because such firms face little or no competition, they have less incentive to innovate or to satisfy consumers. Viewing their customers as a “captive market,” monopolies may offer consumers products of lesser quality or fewer product choices than they would if the market were more competitive.

3. What Is an Oligopoly, and How Does It Limit Competition? The third market structure—oligopoly—is similar to monopoly. It is another form of imperfect competition in which firms exercise considerable market power. However, unlike monopolies, oligopolies are quite common in the real economy. We do business with oligopolies whenever we take a domestic airline flight, buy a new car, or consume a can of soda. Oligopoly: Few Producers, Similar Products An oligopoly is a market or an industry dominated by just a few firms that produce similar or identical products. Oligopoly is one of the less-competitive market structures. On our spectrum of structures, it lies closer to monopoly than to perfect competition. Like monopolies, oligopolies often arise because of economies of scale, which give bigger producers an advantage over smaller ones. In an oligopoly, however, there is at least some competition. In addition, firms in an oligopoly do not have to be large. As an example, if two hardware stores control all the hardware business in a town, then together they make up an oligopoly. The modern American economy has many oligopolies. The airline, automobile, and soft drink industries are oligopolies, as are the industries that produce light bulbs, tennis balls, and large passenger jets. If you go to a grocery store to buy breakfast cereal, for example, you will likely find just four brands: General Mills, Kellogg, Post Holding, and PepsiCo’s Quaker Foods. In 2018, these four companies controlled over 85 percent of the U.S. market for cereal. In aircraft manufacturing, just two companies, Boeing and Airbus, dominated the market for jetliners. Likewise, just three companies dominated the carbonated soft drink market: the Coca-Cola Company, PepsiCo, and Dr. Pepper Snapple Group. Although other companies may be part of these industries, they have little impact on the market. Oligopolies share four main characteristics. Level: A

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Few producers. In an oligopoly, a small number of firms control the market. In general, an industry is considered an oligopoly if the four top producers together supply more than about 60 percent of total output. The proportion of the total market controlled by a set number of companies is called the concentration ratio. For example, the fourfirm concentration ratio in the breakfast cereal industry is 81 percent. Figure 7.3 shows concentration ratios for various oligopolies.

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Figure 7.3 One way to tell whether a market is controlled by an oligopoly is to determine what percentage of market share the four largest firms control. This percentage is called the four-firm concentration ratio. A concentration ratio of greater that 60 percent usually indicates an oligopoly. • Note the highest concentration ratio. Four firms control 93 percent of the market for home refrigerators. • Compare the concentration ratios for pet food and soap detergent. How do those markets differ in terms of the numbers of companies competing for market share?

Similar products. Producers in oligopolies offer essentially the same product, with only minor variations. For example, light bulbs are all very similar. They may come in different shapes and sizes, but they are all close substitutes for one another. The same goes for kitchen appliances, soap, computer chips, and cola drinks. Though some consumers prefer Coca-Cola to Pepsi and vice versa, the two drinks are actually very nearly the same. High barriers to entry. It is hard for new firms to break into an oligopoly and compete with existing businesses. One reason may be high start-up costs. Existing firms may already have made sizable investments and enjoy the advantage of economies of scale. For example, it would cost many millions of dollars to open a new computer chip factory and compete with industry leaders such as Intel. In Level: A

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addition, customers might be reluctant to give up their loyalty to the old brands and try something new.

Some control over prices. Because there are few firms in an oligopoly, they may be able to exert some control over prices. Firms in an oligopoly are often influenced by the price decisions of other firms in the market. This interdependence between firms in setting prices is a key feature of oligopoly. Cooperative Pricing: When an Oligopoly Acts Like a Monopoly When firms in an oligopoly compete for customers, the result can be a fairly competitive market. Often, however, oligopolies behave more like monopolies. Rather than lower their prices to try to win a larger share of the market, firms in an oligopoly may choose to drive prices upward to levels above the market equilibrium price. They may do this in three ways: price leadership, collusion, and cartel formation.

The Organization of the Petroleum Exporting Countries is an international cartel that seeks to control oil supplies and prices. OPEC oil ministers meet regularly to assess global demand for oil and assign production quotas. The quotas set an upper limit on each country’s oil production. This OPEC meeting took place in Vienna, Austria.

Price leadership. In an oligopoly dominated by a single company, that firm may try to control prices through price leadership. The dominant 2020 Teachers' Curriculum Institute

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firm sets a price, and the other, smaller firms follow suit. If the industry leader sets the price high, the other firms benefit. Sometimes, however, the dominant firm may cut prices to take business away from its competitors or even force them out of business. If the other firms also lower their prices, the market is said to be experiencing a price war. Price wars are hard on producers, which might be forced to sell products for less then they cost to make in order to remain competitive, but beneficial for consumers.

Collusion. Firms in an oligopoly may also try to control the market through collusion. Collusion occurs when producers get together and make agreements on production levels and pricing. Collusion is illegal because it unfairly limits competition. Nevertheless, firms sometimes try to get around the law. For example, Apple and five major book publishing companies were accused of collusion aimed at fixing the prices of electronic books, or e-books. In 2013, a federal judge ruled that these companies negotiated with one another to drive up prices.

Cartel formation. A cartel is an organization of producers established to set production and price levels for a product. Cartels are illegal in the United States, but they do sometimes operate on a global scale, most often in the commodities markets. For example, nations that produce coffee, sugar, and tin have all tried to form cartels in the past. The Organization of the Petroleum Exporting Countries is the bestknown modern cartel. OPEC consists of about a dozen countries that agree to set quotas on oil production and exports. By setting limits on the supply of oil, OPEC exerts a major influence on world oil prices. The market power of a cartel like OPEC underscores the potentially harmful effects of oligopolies on consumers. When firms in an oligopoly work together to control the market, they act much like a monopoly. As such, they can use their market power to limit competition and raise prices.

4. What Is Monopolistic Competition, and How Does It Affect Markets? The fourth market structure, monopolistic competition, is the one we Level: A

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encounter most often in our daily lives. When we eat in a restaurant, buy gas at a gas station, or shop at a clothing store, we are doing business in monopolistically competitive markets. Monopolistic Competition: Many Producers, Similar but Varied Products In monopolistic competition, a large number of producers provide goods that are similar but varied. Like oligopoly, this market structure falls between the extremes of perfect competition and monopoly. However, it lies on the more competitive end of the spectrum. The shoe business is a good example of monopolistic competition. If you go to a discount shoe store, you will find hundreds of pairs of shoes on display, made by many different companies. Each company has marked its shoes with its own brand, or trade name. Each has worked to make its line of shoes distinctive in style, color, material, or quality of construction. Because of these differences, shoes are not commodities. Therefore, the shoe industry does not fit the model of perfect competition. At the same time, the sheer number of shoe producers indicates that the shoe industry is neither a monopoly nor an oligopoly. You might well wonder why a market like this would be called monopolistic. The main reason is that the goods offered by the competing brands are distinct enough to appear unique. As a result, customers may develop brand loyalty, favoring one company over all others. Such customer loyalty gives the favored company some degree of market power. In effect, the company “monopolizes” its brand and can charge more for it. Monopolistic competition is especially common in service industries, such as banks, auto repair shops, and supermarkets. But as our shoe example indicates, it also exists in many manufacturing industries. Monopolistic competitions share four basic characteristics.

Many producers. Monopolistically competitive markets have many producers or sellers. In a big city, many restaurants compete with one another for business. The same is true for gas stations and hotels.

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In monopolistically competitive markets, firms use nonprice competition to attract customers. This supermarket sets itself apart from the competition by selling locally grown and organic foods and projecting an eco-friendly image.

Differentiated products. Firms in this type of market engage in product differentiation, which means they seek to distinguish their Level: A

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goods and services from those of other firms, even when those products are fairly close substitutes for one another. For example, a pizza stand and a taqueria both offer fast foods. A customer may have a taste for one type of food over the other, but either will provide a suitable lunch.

Few barriers to entry. Start-up costs are relatively low in monopolistically competitive markets. This allows many firms to enter the market and earn a profit. For example, it does not cost much to get into the custom T-shirt business. That means that an entrepreneur with a good set of T-shirt designs may be able to open a shop or create a website and sell enough shirts to make a profit. Some control over prices. Because producers control their brands, they also have some control over prices. However, because products from different producers are close substitutes, this market power is limited. If prices rise too much, customers may shift to another brand. In addition, there are too many producers for price leadership or collusion to be feasible. Increasing Market Share Through Nonprice Competition To compete with rival firms, producers in monopolistically competitive markets have to take price into consideration. But they also engage in nonprice competition, using product differentiation and advertising to attract customers. By convincing consumers that their brand is better than others, these producers hope to increase their firm’s market share, or proportion of total sales in a market. Nonprice competition typically focuses on four factors.

Physical characteristics. There are many kinds of products that consumers will pay more for because of their unique physical characteristics. For example, a pair of running shoes may stand out from its competitors because of the shoe’s unique design, color, or materials. A consumer who likes that particular shoe may not consider buying any other pair, regardless of price. Service. Some producers offer better service than others and can therefore charge higher prices. For example, a fast food chain and a sitdown restaurant both offer food, but the more expensive restaurant also offers table service. Upscale grocery stores may offer their customers free food samples or special services, such as food delivery and catering. Some department stores provide personal shopping assistants to help customers make selections. Such enhanced services may appeal to consumers who are willing to pay for them. 2020 Teachers' Curriculum Institute

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Location. Gas stations, dry cleaners, motels, and other businesses may compete with one another based on location. Although they offer the same basic product or service, a firm may win customers because it is located near a highway, a shopping mall, or some other convenient spot. Status and image. Sometimes companies compete on the basis of their perceived status or trendiness. One brand may be regarded as more exclusive, more “natural,” or more fashionable than another. For example, a handbag from an expensive boutique may have greater status in a customer’s eyes than a similar bag from a discount store. Another customer may willingly pay more for designer jeans, even though they can purchase a similar product without the designer label for much less money. These perceived status differences are usually established through advertising. Although advertisers often provide information about their products in ads, their main goal is to increase their sales and market share.

5. Market Failures: What Are Externalities and Public Goods? As our survey of market structures shows, most market structures fall into the broad category of imperfect competition. Because these structures do not allocate goods and services in the most efficient way, economists call them market failures. However, imperfect competition is not the only form of economic inefficiency. Externalities and public goods are also evidence of market failure. Externalities: Costs and Benefits That Spill Over An externality is a side effect of production or consumption that has consequences for people other than the producer or consumer. You might think of externalities as spillover effects, either costs or benefits, resulting from the actions and decisions of companies or individuals. Externalities occur in many ways and take many forms. When a factory dumps chemical waste into a river and the polluted water affects the health of people who live downstream, that is an externality. If a neighbor plants a new flower garden and the results please you, that is also an externality. If that same neighbor holds a party with loud music that keeps you up at night, that is an externality, too. In fact, it is an externality if you hear the music at all, whether you like it or not. Level: A

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Now, consider a more complicated example of spillover effects. Suppose that a corn syrup factory, run by a firm called Acme Corn Syrup Company, produces an unpleasant odor, and every day that odor drifts into a nearby neighborhood. The odor is an externality by itself, but it has other side effects as well. Because of the smell, some people in the area decide to sell their homes. The odor is so bad, however, that no one wants to buy the houses, and house prices fall as a result.

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A college education is a good example of a positive externality. Each individual’s consumption of a good— in this case, higher education— will create a benefit for society in the form of a more productive workforce.

An economist would consider the decline in property values around the factory to be a cost of corn syrup production, but it is not a cost paid by Acme Corn Syrup Company. Rather, this cost is external to the company and is borne by homeowners in the community. That external cost is an externality. There are two types of externalities: negative and positive. A negative externality is a cost that falls on someone other than the producer or consumer. This cost may be monetary, but it may also simply be an undesired effect. Most of the examples discussed above are negative externalities. A positive externality, on the other hand, is a benefit that falls on someone other than the producer or consumer. If you enjoy hearing the music from a neighborhood party, that spillover sound is a positive externality. Other examples include the broader benefits of getting an education or developing a less polluting car. Students who get a college education benefit directly by getting higher-paying jobs. But if their success also results in greater economic prosperity for their communities, that is a positive externality. In the same way, if a car company designs a new car that emits fewer pollutants, the company may benefit from increased sales. But society benefits, too, as a result of reduced air pollution. Another type of positive externality is known as a technology spillover. Level: A

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The benefit from a technology spillover results when technical knowledge spreads from one company or individual to another, thereby promoting further innovations. For example, other car companies might expand on the less-polluting car design to make additional improvements in pollution control. Those improvements are a technology spillover. How Externalities Reflect Inefficiency Although positive and negative externalities have very different results, they are both examples of inefficiency and market failure. That is because they fail to factor all costs of production and all benefits to consumers into the model of supply and demand. To understand what this means, consider the case of negative externalities generated by our imaginary corn syrup company. When Acme produces corn syrup, it incurs a private cost. This private cost, however, does not take into account the external cost paid by others as a result of Acme’s pollution. If Acme were to factor in this external cost, its total cost of production would increase. To make up for this extra cost, Acme would have to increase the price of corn syrup. In response to a price increase, the quantity of corn syrup demanded would most likely decrease. Acme would then have to lower its output to match the shrinking demand. The fact that these changes in price and quantity demanded do not occur under ideal market conditions is a sign that the market is not working efficiently. The result is that goods that generate negative externalities tend to be overproduced because their full cost is not reflected in the market price. The reverse is true of goods and services that generate positive externalities. They tend to be underproduced relative to their benefits. Consider a beekeeper who sells honey for a living. The money she makes from her business is her private benefit. The beekeeper’s neighbors, however, receive an external benefit when her bees pollinate their flowers and fruit trees at no cost. They may wish that she would double her number of hives. But unless the beekeeper can reap a private benefit from doing so, she is unlikely to expand her business no matter how much it might benefit her neighbors. The Problem of Public Goods Another example of market failure involves public goods—goods and services that are not provided by the market system because of the difficulty of getting people who use them to pay for their use. Examples of public goods include fire and police services, national defense, and public parks. Public goods are the opposite of private goods, or goods and services that are sold in 2020 Teachers' Curriculum Institute

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markets. Economists make two key distinctions between public and private goods. First, private goods are excludable. This means that anyone who does not pay for the good can be excluded from using it. A grocery store, for example, will sell apples only to customers willing to pay for them. Public goods, on the other hand, are nonexcludable. Think of streetlights. How could you prevent some people from using the light from streetlights? You could not, so this makes them nonexcludable. Second, private goods are said to be rival in consumption , which means that a good cannot be consumed by more than one person at the same time. Thus, for example, if you buy an apple and eat it, that apple is no longer available for anyone else to eat. In contrast, public goods are nonrival in consumption . One person’s use of a streetlight’s glow does not diminish another’s ability to use its light as well. Based on these two characteristics, you can see why things like parks and sidewalks are considered public goods. No one can be excluded from using them, and anyone can enjoy their benefits without depriving anyone else. These two characteristics also explain why private firms do not provide use with these public goods. Because they have no way to make the people who benefit from nonrival and nonexcludable goods pay for them firms have little incentive to create them. Economists call this situation the free-rider problem.

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A Fourth of July fireworks show put on by a city is an example of a public good. The city could make the show a private good by setting up a fence and selling tickets, but it could not prevent “free riders” from watching the show from outside the gates.

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provided them would want to charge the people who use them. But street lighting is not excludable, so anyone who passes under a streetlight can take a “free ride” by using the light and not paying for it. Because of these free riders, no private business will provide street lighting. The result, from the point of view of economists, is a market failure. Externalities and public goods remind us that markets do not always work perfectly. As a matter of fact, they do not work perfectly much of the time. However, this does not mean that the market system is fatally flawed. Despite its weaknesses, the market system is still the most effective, efficient, and flexible way for all of us to get the things we want and need.

Summary There are four basic market structures, each with different characteristics. Because only one of these structures is perfectly competitive, economists classify the other three as examples of imperfect competition and, therefore, as market failures. What is perfect competition, and why do economists like it so much? Perfect competition is the most efficient and competitive market structure. It consists of many producers who provide identical goods, usually referred to as commodities. Prices are established by the interaction of supply and demand. What is a monopoly, and why are some monopolies legal? A monopoly is the opposite of perfect competition. In a monopoly, a single producer provides a unique product and therefore has significant control over prices. The government permits certain kinds of monopolies to exist because they are believed to serve the public interest. What is an oligopoly, and how does it limit competition? An oligopoly is a market dominated by a small number of producers who provide similar, but not identical, goods. Firms in an oligopoly often set prices based on other firms’ pricing decisions. Because oligopolies can dominate markets, their effect may be much like that of a monopoly. What is monopolistic competition, and how does it affect markets? Monopolistic competition is a market in which many producers provide a variety of similar goods. Such markets are characterized by the use of nonprice competition to differentiate Level: A

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products and build brand loyalty. To the extent that firms “monopolize” their own brands, they may have some control over prices, but such markets remain relatively competitive. Market failures: What are externalities and public goods? Externalities are side effects of production and consumption. They may be positive or negative. Public goods are goods that are available for all people to consume, whether or not those people pay for the goods. Externalities and public goods are both symptoms of market failure.

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Examining Perfect Competition Economic Question: Do industries always benefit from perfect competition?

Inquiry Introduction In this unit, you examined how market structure affects how different industries operate. Now, you will apply what you have learned in this Economic Inquiry. You will investigate the Economic Question by considering the effects of implementing perfect competition in an industry that functions as a monopoly or oligopoly.

Storyline Suppose a respected financial news site plans to publish a series on economic competition to celebrate its merger with a rival website. The site’s editors ask several writers to contribute an article to this series, including you, a financial journalist. The editors tell you to choose your own topic, so you decide to examine perfect competition. You are intrigued by the idea that economists view perfect competition as the most efficient market structure in terms of allocating resources. If it is so efficient, why don’t most industries operate under this market structure? And what would happen if perfect competition replaced a monopoly or oligopoly? To prepare to write your article, you will conduct research on an industry, identify the advantages and disadvantages of its current market structure, and determine how perfect competition would affect the industry’s operations. You will then use this information to write an article evaluating whether perfect competition would improve how this industry functions.

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This 1955 car was manufactured by Studebaker, one of the U.S. auto manufacturers that thrived into the postwar era. However, by the 1950s, it was unable to compete as costs climbed, and Packard, another American car manufacturer, took over the company. The last Packard rolled off the assembly in 1956, and the final Studebaker was built in 1966.

Background Monopolies can result when a company actively seeks to control the market. For example, throughout the 20th century, the company De Beers worked to expand its reach and maintain its monopoly on the diamond industry. In the company’s early years, it expanded because smaller mining companies and individual claim holders benefited from joining larger ones that offered better access to equipment, infrastructure, and land. Over time, it set up its own distributors, bought competitors, marketed directly to consumers, and required suppliers and buyers to enter exclusive contracts, which gave the company a tight grip on the diamond industry. Oligopolies may form in a similar manner. One example is the U.S. auto industry in the mid-20th century, before cars from foreign automakers were widely available. In the industry’s early years, hundreds of automakers came and went, but by the late 1920s, the Big Three— Level: A

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General Motors, Ford, and Chrysler—were dominant. They grew by buying smaller companies and suppliers. By the 1950s, the Big Three’s economies of scale made it difficult for smaller brands to compete.

In this activity, you and a partner will evaluate how perfect competition would affect an industry that operates as either a monopoly or oligopoly. By going through to the inquiry process, you can investigate whether an industry would benefit from perfect competition’s advantages.

Inquiry Process As you consider the Economic Question, you may wonder how to determine the effects of perfect competition in an industry that operates as a monopoly or oligopoly. To conduct an inquiry, you can follow these steps and record your findings in your Interactive Student Notebook: Choose an industry that operates as a monopoly or oligopoly as the topic of your article, and describe the industry. Develop supporting questions to help you answer the Economic Question. You may want to ask questions about the industry in 2020 Teachers' Curriculum Institute

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terms of the four characteristics that define market structure (number of producers, similarity of products, ease of entry, and control over prices) and how the industry’s market structure developed. Research answers to your questions. As you conduct research, record and evaluate your sources. Make sure that the sources you are using are reliable. Use the information you gathered to create a list of advantages and disadvantages of the industry’s market structure. Consider these from the perspective of producers and consumers. Assess how perfect competition would affect the industry’s operations and determine how it would alter the advantages and disadvantages of the industry’s market structure. Write an article in which you evaluate whether perfect competition would improve your chosen industry. The article should include an introduction with a thesis statement, body paragraphs, and a conclusion. Use evidence from your research and reasoning to support your article’s argument. By following these steps, you will better understand how market structure supports an industry’s operations and whether perfect competition is always preferable. When you are ready, work with your partner and begin investigating the Economic Question.

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Money, Banking, Saving, and Investing How should you spend, save, and invest your money?

Vocabulary Glossary Vocabulary Cards bank assets credit card debit card saving interest principal investing diversification

Introduction

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People spend, save, and invest their money in various ways.

If you had only a paperclip to trade, what do you think you could get for it? If your answer is not much, think again. In 2005, Kyle MacDonald, an unemployed 25-year-old from Montreal, Canada, traded one red paperclip for a house. Well, actually he started with the paperclip, and 14 trades later he ended up with a house. How did he do it? MacDonald posted each of his trade offers online using a popular trading site and his own website. His purpose was clear from the start. “I’m going to make a continuous chain of ‘up trades’ until I get a house,” he wrote on July 12, 2005. MacDonald promised to go anywhere to make a trade. In Vancouver, British Columbia, he traded the red paperclip for a pen shaped like a fish and then he went to Seattle, Washington, for a sculpted doorknob. He traveled to Massachusetts for a camping stove, California for a generator, and New York for supplies to throw a party. The next trade, for a snowmobile, made a huge impact on MacDonald’s journey. The trader was a well-known radio and television personality in Quebec. Soon, the national media in Canada and the United States Level: A

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were running stories about the “paperclip guy.” The trades came fairly quickly after that—a trip to a town in British Columbia, a van, a recording contract, and a year’s free rent of a house in Phoenix, Arizona. In the next few months, he “up traded” an afternoon with rock star Alice Cooper for a fancy motorized snow globe, the globe for a movie role, and the movie role for—yes—a house. Through barter, with no exchange of money, MacDonald had turned a red paperclip into a house in one year’s time. Kyle MacDonald’s triumph proved that barter is alive and well in our market economy, but did it also show that money is obsolete? It did not. If anything, MacDonald showed how much we need money—even to accomplish a wildly successful series of barters. Throughout his adventure in bartering, MacDonald relied on money to meet his everyday wants and needs. Money made MacDonald’s bartering adventure possible. He used money to pay for food, clothing, shelter, phone calls, airplane trips across the continent, and whatever else he needed to chase his dream. That was his choice. You have also probably made choices about what to do with your hard-earned cash. Those choices will only become more complicated as you take on more responsibility for supporting yourself. This lesson may help make that transition easier by giving you some insight into how you might choose to spend, save, and invest your money.

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Starting with a red paperclip, Kyle MacDonald traded his way up to this house. While his bartering experiment was successful, most people rely on money to purchase things that they need.

1. What Makes Money . . . Money? Kyle MacDonald managed to get the house he wanted by bartering. To do this, he relied on a coincidence of wants. People wanted what he had, and he wanted what they had. MacDonald also relied on the publicity his adventure generated. Media stories of the “paperclip guy” brought him lots of eager traders. Of course, MacDonald could have used money to buy a house. With money, you don’t need coincidence or publicity to get the things you want. Producers readily accept money in return for goods and services. When economists define money, they focus on that acceptability. Money, they say, is anything that is generally accepted as a means of payment. Economists further describe money according to its main functions and characteristics. Money Has Three Basic Functions Money is obviously useful to us in our economic lives. In fact, it is hard to imagine living without it. Money functions in three key ways: as a medium of exchange, as a standard of value, and as a store of value.

Medium of exchange. Money is a medium, or means, of exchange. It enables us to carry out trade and commerce easily, much more easily Level: A

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than through barter. For example, rather than trying to find someone willing to take, say, a dozen pairs of flip-flops in trade for a new backpack, you can just hand a store clerk a quantity of dollars—the established medium of exchange in the United States. U.S. dollars are this country’s legal tender—they must be accepted as money for purchases and as payment for a debt.

Standard of value. Money also serves as a standard of value. It allows us to measure and compare the value of all kinds of goods and services using one scale. If we had no standard of value, it would be much harder to compare prices. For example, imagine seeing advertisements from two stores. One advertises a backpack for sale for nine pairs of flip-flops. The other has the same backpack advertised for five T-shirts. Without a common standard of value, how would you know which backpack costs more? Store of value. Something is a store of value if it holds its value over time. A banana would be a poor store of value because it spoils quickly. A rotten banana has lost much or all of its original value. Money, however, holds its value over time. Put another way, money maintains its purchasing power over time. Purchasing power refers to the quantity of goods and services that can be bought with a particular sum of money. The $5 you have in your pocket today will buy $5 worth of goods or services now and for some time into the future. This stability allows you to hold on to your money, knowing you can spend it just as well tomorrow as today. Although money stores value very well, it is not a perfect store of value because prices tend to rise over time. For example, your $5 will always get you $5 worth of pencils. However, the number of pencils you can get for that price may decrease over time. Money Has Six Main Characteristics For money to perform its three primary functions well, whatever people use as money should exhibit the six characteristics listed below. As you read about these characteristics, think about how well they apply to a substance that was once widely used as money: salt.

Acceptability. The most important characteristic of money is acceptability. In order for you to buy something, the seller must be willing to accept what you offer as payment. In the same way, when you sell your services, you must be willing to accept what your employer offers as payment, or wages, in exchange.

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In ancient times, traders throughout the Mediterranean region accepted salt as a medium of exchange. Roman soldiers received, as part of their wages, an allotment of salt known as a salarium. From that Latin term comes the English word salary.

Scarcity. Whatever is used as money needs to be scarce enough to be valued by buyers and sellers. Throughout history, many cultures have used gold or silver as a medium of exchange. The relative scarcity of these metals adds to their value. If gold and silver were as common as sand, these metals would cease to be used as money. In ancient times, salt was scarce in many parts of the world. Yet, the demand for salt was great. People seasoned and preserved foods with salt and used it in religious ceremonies. Scarcity, coupled with a high demand for it, made salt a valued commodity.

Portability. To be convenient as a medium of exchange, money must be portable. People must be able to carry it with them easily. Salt is portable—to some extent. But imagine lugging several large bags of salt with you to the mall. And think about the mess you might make paying for a pair of jeans with three cups of salt. By today’s standards, salt fails the portability test.

Durability. If money is to serve as a store of value, it must be durable. Moreover, any medium of exchange must be able to withstand the physical wear and tear of being continually transferred from person to person. Salt can last a long time, but only if kept dry. Think how you would feel if a rainstorm dissolved and washed away your fortune. Salt fails the durability test.

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Divisibility. To be useful as a medium of exchange, money must be easy to divide into smaller amounts. To understand why, imagine an economy that uses glass bowls as its medium of exchange. Buyers in that economy would be unable to buy anything worth less than one bowl, because the seller would be unable to provide change. Shards of broken glass would be too hazardous to use as change for something worth just half of a bowl. A bag of salt, on the other hand, can be split into ever-smaller amounts. This ease of divisibility once made salt a useful medium of exchange.

Uniformity. A dollar is a dollar is a dollar. We take for granted that each dollar bill is the same as the next. Why is such uniformity important? Consider an economy in which pumpkins are the chosen medium of exchange. Pumpkins come in all sizes and weights. Could a large pumpkin be exchanged for more goods than a small pumpkin? How would producers and consumers agree on the value of any one pumpkin? Like dollar bills, all salt is pretty much the same. Thus, salt passes the uniformity test, as it does the tests of acceptability, scarcity, divisibility, and—for ancient traders—portability. Historically, salt had most of the characteristics of a useful medium of exchange. 2020 Teachers' Curriculum Institute

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A Brief History of Money Gold, silver, and salt have all served as money at some time in history, and so have shells, cattle, beads, furs, and tobacco. Economists categorize all of these items of exchange as commodity money. A commodity—a good that has value in trade— becomes commodity money when it is used as a medium of exchange. The value of commodity money is about the same as the value of the commodity it consists of.

Commodity money was used for thousands of years, all over the world. Of all the many commodities used as money, precious metals such as gold and silver were historically preferred over other forms of commodity money. These metals had all the useful characteristics of money since they were scarce, portable, durable, divisible, and, best of all, acceptable. In the form of bars and coins, these metals could even be made uniform. As trade flourished in Europe during the Renaissance, wealthy merchants and nobles needed safe places to store their gold and silver bars and coins. In large cities, private banks arose to meet this need. A bank is a business that receives deposits and makes loans. A loan is a transaction in which a lender gives money to a borrower, who agrees to repay the money in the future. Level: A

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These early banks accepted depositors’ precious metals and in return gave the depositors elaborate paper receipts known as banknotes. The banks promised to exchange these banknotes for gold or silver “on demand”—that is, whenever the holder asked for such an exchange. Economists call banknotes given in exchange for gold and silver commodity-backed money, or representative money. The notes had minimal value themselves. One could not eat them, wear them, or otherwise consume them. As commodity-backed money, they had value only as a medium of exchange. These banknotes were the forerunners of modern printed money issued by governments. However, there is a big difference between the two. Most paper money today is no longer backed by gold, silver, or any other commodity. It has value only because it is generally accepted as a means of payment. That acceptance comes in part because governments declare that the paper notes they issue are money. You can read this declaration, for example, on any bill issued by the U.S. government:

This note is legal tender for all debts, public and private. In the past, such government decrees were known as fiats. Thus, paper money issued without the backing of gold or silver is known as fiat money.

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Figure 8.1 In the 1990s, the Treasury Department began redesigning U.S. currency to make it harder for counterfeiters to create fake bills. The redesigned $20 bill went into circulation in 2003. Which aspect of the redesign do you think would be the most difficult for a counterfeiter to copy?

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Using the M1 definition, only currency, deposits in checking accounts, and traveler’s checks are liquid enough to qualify as money. Credit cards, checks, and debit cards can be used to access cash, but are not themselves money.

U.S. dollars may not be backed by gold or silver, but they are backed by the full faith and credit of the U.S. government. As long as consumers believe they can purchase goods and services with dollars, people will continue to use dollars as a medium of exchange. What Counts as Money Today When people nowadays think of money, they most often think of cash, in the form of paper bills or metal coins. Together, bills and coins circulating throughout the economy are known as currency. Currency, however, is only part of a nation’s money supply, or the total amount of money in the economy. What else counts as money? The answer depends on the kinds of assets economists choose to count as money in addition to currency. The most common measure of money used by economists today is known as M1. Besides coins and bills, M1 includes liquid assets that can be used as cash or can easily be converted into cash. Currency makes up about half of the M1 money supply. Most of the rest consists of what economists call checkable deposits, or deposits in bank checking accounts. Depositors can write checks on these accounts to pay bills or make purchases. A check is a signed form instructing a bank to pay a specified sum of money to the person named on it. Checks themselves are not considered money, but the deposits they 2020 Teachers' Curriculum Institute

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access are. The M1 money supply, then, is made up of currency and checkable deposits. What about money deposited in savings accounts? Savings account deposits are considered near-money. Although savings account funds can usually be transferred to a checking account fairly easily, they are not used directly to buy things. For example, you cannot go into a store with your savings account statement and buy a pair of shoes. Because people’s savings are not as liquid as cash, economists put them into a second category known as the M2 money supply. M2 consists of M1 plus money saved in various kinds of accounts or funds. You can buy a pair of shoes with a credit card. But even though people sometimes call their credit cards “plastic money,” economists do not regard credit cards as a form of money. To see why, consider what the term credit means. Credit is an arrangement that allows a person to buy something now with borrowed money and pay for it later or over time. Each purchase with a credit card creates a loan that the user must pay back to the bank, store, or other business that issued the card. The credit card is a convenient means for taking out such a loan—so convenient that since 2003, credit card purchases have outnumbered those made with checks or cash. But the card itself is not money. You can also buy shoes with a debit card, which allows you to access the money in your bank account. Used at a store, a debit card electronically transfers funds from your account to the store’s account. Although it is a handy tool for accessing money, a debit card, like a check, is not itself considered part of the money supply.

2. How Does the Banking System Work? What do you notice when you enter a bank? Perhaps you pass an automated teller machine in the lobby. ATMs can dispense cash, accept deposits, and make transfers from one account to another. You may see desks and offices on the main floor. There are probably bank tellers behind a counter ready to assist you. Beyond the counter, there may be a large vault for storing money and other valuables. The process seems fairly straightforward. Money comes in, and money goes out. The bank keeps track of every penny. But what goes on behind the scenes? How does your bank fit into the whole banking system? Level: A

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The Elements of the Banking System Banks are financial institutions— firms that deal mainly with money, as opposed to goods and services. Like all financial institutions, a bank must have a charter from the state or federal government that spells out how it will operate and be regulated. There are several kinds of banks, including commercial banks, savings and loans, mutual savings banks, and credit unions. Historically, commercial banks served business and industry. The others focused on consumers, encouraging them to embrace the idea of saving—putting money aside for later. Today, there are few differences between the various types of banks. All banks work with businesses and consumers and offer the same basic kinds of services. Banks Offer a Range of Services A bank’s main function is to serve as a financial intermediary—an institution that brings together sellers and buyers in financial markets. The sellers and buyers that banks bring together are savers and borrowers. Banks help transfer assets from one to the other. Specifically, banks receive deposits from savers and make loans to borrowers, which are the two main services that banks deliver.

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Many farmers take out commercial loans to pay for expensive equipment, like this harvester, that they may not have been able to afford upfront.

Banks also serve consumers in a variety of ways. They cash checks, issue credit cards, change foreign currency into dollars and vice versa, and provide safe-deposit boxes for storing valuables. Banks also offer the convenience of electronic banking through ATMs, debit cards, direct deposit of paychecks, and automatic payment of bills. Many banks also provide services on the internet so that customers can monitor their accounts, pay bills, and transfer money from one account to another. Banks Receive Customers’ Deposits A time-tested way to save money is to deposit it in a bank. Banks offer three kinds of deposits: checkable deposits, savings deposits, and time deposits. Each bank has its own rules about when savers can withdraw deposited money. As a result, accounts vary in their liquidity, or the ease with which they can be converted into cash. They also vary in their return or the amount of earnings they generate.

Checkable deposits. A checkable deposit is an amount of money placed in a checking account. Checkable deposits are highly liquid. That is, they can easily and quickly be converted into cash. You can withdraw money deposited in a checking account on demand any time you wish. This withdrawal once called for writing a check. Today, however, most checking accounts can be accessed electronically using the internet, a debit card, or an ATM. Money in a checking account, however, earns little or no interest. Interest is money paid periodically in return for the use of borrowed funds. Checkable deposits, then, provide safety and liquidity, but do not Level: A

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provide much in the way of earnings.

Savings deposits. Money deposited in a savings account earns more interest than checkable deposits, although the return is still low. Funds can be held for any length of time, and the entire deposited amount can be withdrawn on demand. Savings deposits are only slightly less liquid than checkable deposits. Savers usually make withdrawals from savings accounts by using ATMs or by presenting withdrawal slips to bank tellers. Time deposits. Savers who want higher returns can put their money into certificates of deposit (CDs). The trade-off for these higher returns is lower liquidity. CDs, also known as time deposits, tie up cash for a set period of time—typically several months or longer. If you take your money out of a CD before the end date, you will pay a penalty that amounts to a percentage of the interest you would have earned. Why are people willing to trust their money to banks? The main reason is safety. The risk, or chance of losing money, is very low with any bank deposit, thanks to the Federal Deposit Insurance Corporation. Congress established this federal agency in 1933 to help stabilize the banking system during the Great Depression. Today, nearly all bank deposits are insured by the FDIC for up to $100,000 per depositor. Should a bank fail, the FDIC guarantees that depositors will get their money back up to that amount. Banks Make Loans to Borrowers Banks use the money deposited by savers to make loans to other customers. Bank loans come in three forms: commercial loans, consumer loans, and mortgage loans.

Commercial loans. Businesses often take out commercial loans to buy machinery, equipment, and materials or to pay labor costs. Before making such a loan, banks consider the firm’s financial condition and borrowing history as well as the general state of the economy. Consumer loans. Individual borrowers take out consumer loans to make major purchases such as a new car or boat. These loans are often called installment loans, because most are paid back in equal monthly installments, or payments. Before making a consumer loan, the bank looks at the individual’s credit history. This is a history of the person’s past borrowing along with their record of repaying loans on time and in full. Individuals can take out loans to buy smaller items by making their purchases with a credit card. Using a credit card is easy—so easy that 2020 Teachers' Curriculum Institute

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many people charge more than they can afford. Those who cannot pay off their credit card bills each month are charged interest on their unpaid balances by the bank that issued the card. Interest rates for credit card debt are generally much higher than for other kinds of loans. For many cardholders, the result of overcharging is an everincreasing pile of debt.

Mortgage loans. Banks also offer longer-term loans to consumers and businesses in the form of mortgages. A mortgage is a loan used to buy a house, an office building, land, or other real estate. The term of a mortgage typically ranges from 15 to 30 years. As with any loan, a mortgage is part principal—the amount of money actually borrowed— and part interest on the principal. You might be surprised at the total cost of paying off a home mortgage. A house purchased for $220,000 with a traditional 30-year mortgage at a fixed interest rate of 5 percent per year, and paid in monthly installments, could end up costing the buyer more than $400,000 by the time the loan is paid off. How Banks Make a Profit In their role as financial intermediaries, banks channel funds from savers to borrowers by taking money deposited into various accounts and using it to make loans. In the process, banks profit by charging more interest on loans than they pay on deposits. For borrowers, interest represents the cost of using someone else’s money. For savers, interest represents payment for letting someone else use their money. How, you might wonder, can a bank lend out depositors’ money and still promise to return that money to its depositors on demand? The answer is that banks do not lend out all the money they take in. They are required by law to keep a certain fraction of it in reserve to cover depositors’ withdrawals from their accounts. For example, suppose you deposit $1,000 into a checking account. Your bank may be required to keep one-tenth, or $100, in reserve. That would leave $900 for the bank to lend out and charge interest on.

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Figure 8.2 All credit cards display the same basic information. Account data are also stored on the card’s magnetic strip. Stores and businesses use this information to identify the cardholder and verify that an account is in good standing.

The Federal Reserve, headquartered in Washington D.C., has a wide range of tasks that make sure the banking system runs smoothly. This includes controlling the nation’s money supply, clearing checks, and holding reserves.

This system—whereby banks keep a fraction of deposits in reserve and make loans with the rest—is known as fractional reserve banking. 2020 Teachers' Curriculum Institute

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The system keeps enough money available for withdrawals while allowing banks to profit from the rest. The fraction that banks are required to keep on hand is set by the Federal Reserve System, which was established in 1913 to oversee the banking system. The Federal Reserve: Our Nation’s Central Bank The Federal Reserve System, commonly known as the Fed, is the central bank of the United States. A central bank does not serve individual consumers and businesses, and making a profit is not one of its goals. The Fed’s customers are the nation’s thousands of banks, and its goals involve keeping the entire banking system stable and healthy. The Fed provides several important financial services.

Holding reserves. The Fed requires each bank to keep a fraction of its deposits in reserve. Some of that reserve takes the form of currency in the bank’s vault, and some goes into an account set up for the bank at the Fed. In this way, the Fed serves as a bank for other banks. Providing cash and loans. When a bank needs cash to meet withdrawal demands, the Fed supplies it from the bank’s account. The Fed also lends money to banks when they run short of funds. Clearing checks. If you write a check to a store and the store deposits the check into its account with a different bank, the Fed takes care of transferring funds from your bank to the store’s bank. This process is known as check clearing. The Fed clears billions of checks each year. Linking banks electronically. The Federal Reserve and nearly all of the nation’s banks are linked electronically. Using this electronic network, banks can quickly transfer funds from one financial institution to another. The Fed Manages the Banking System The Federal Reserve does more than provide services. The Fed also manages the banking system to ensure that banks operate according to sound financial principles. Another important job of the Fed is to control the nation’s money supply. It does this in part by setting reserve requirements, the minimum fraction of deposits that banks must keep in their own vaults or at the Federal Reserve. The Fed also issues Federal Reserve notes, the paper currency we know as dollars. Through all of its activities the Fed aims to provide liquidity—to make sure consumers and businesses have ready access to money. The Fed’s structure aids in the task of managing the banking system. A seven-member Board of Governors oversees the Federal Reserve Level: A

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System from its headquarters in Washington, D.C. From there, it formulates Fed policies related to the money supply and sets reserve requirements. Twelve regional Federal Reserve Banks carry out many of the system’s dayto- day activities. Each Reserve Bank provides financial services to its region’s banks and supervises their operations. Reserve Banks also feed economic information about their regions to the Board of Governors. About 40 percent of the banks in the United States are members of the Federal Reserve System. Members include all national banks— commercial banks chartered by the federal government—and many state-chartered banks. All commercial banks, whether Fed members or not, enjoy the same privileges when it comes to borrowing from the Fed and must follow its regulations. And, when the Fed adjusts the money supply, all banks feel the effects.

3. How Is Saving Important to the Economy—And to You? Thirty years ago, Americans saved more of their incomes than they do today. Economists know this by measuring Americans’ personal saving rate— the proportion of a household’s income that its members save each year. Figure 8.3A shows that in the early 1980s, the personal savings rate often topped 10 percent. By 2018, it had fallen to about 6 percent. That means the average American household is setting aside almost none of its income for the proverbial rainy day. Should we be concerned about our general lack of thrift? Does the future-consequences-count principle matter when it comes to saving?

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Figure 8.3A Americans aren’t saving the way they used to. As this graph shows, the percentage of income that we put into savings has dropped in recent years. And yet saving for the future is vitally important—both to individuals and the economy.

Saving Helps the Economy Grow The money you and others set aside in savings accounts, retirement plans, and other forms of saving is not just important to you personally. This money also contributes to the nation’s overall economic growth. How does this work? Personal savings provide funds that banks can lend to businesses for expansion—what economists call investment in capital goods. When businesses invest in capital goods, the economy grows. For example, suppose a company borrows money to build a new factory. The new factory increases the company’s output. More goods are produced and sold, creating growth in the economy. Building a factory also generates growth indirectly. It provides revenue to a host of other producers, from construction companies to equipment suppliers. Those producers can then launch their own Level: A

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expansions. A new factory also creates jobs. The workers’ wages flow to local businesses. Wages also flow into the bank accounts of the workers themselves. Banks use these deposits to start another round of lending and even more economic growth. Saving Can Help You Reach Important Goals To most Americans, the idea of saving money is less exciting than the idea of spending it. As our personal saving rate suggests, we are a nation of consumers. Saving part of one’s income, however, does not mean never consuming it. In fact, some economists define saving as “consuming less now in order to consume more in the future.”

Saving money can help you when you get stuck with an unexpected expense, such as your car breaking down. Without the money to fix your vehicle, you may find yourself unable to get to work or school.

We all have goals for the future. Perhaps your goal is to become a lawyer, an engineer, or a teacher. To do that you will need a college degree. Maybe your goal is to buy your own car or house. Maybe you dream of traveling the world or starting a business. Whatever your goal, it is likely to require money. Setting aside a portion of your income now to cover later expenses is saving for the future. Saving Can Help You Weather Hard Times Do you know anyone who lived through the Great Depression? That person could tell you about hard times—businesses ruined, homes and life savings lost, few jobs, and little hope. The Depression affected nearly everyone in the United States to some degree. 2020 Teachers' Curriculum Institute

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Even when the economy is strong overall, financial misfortune can strike at any time—when a company lays off workers, when a business fails, or when a family gets hit with huge medical bills. Such events often come unexpectedly. Unless you are ready, you could find yourself facing real financial hardship. To be prepared for a financial emergency, experts advise building up a “rainy-day fund”—an easily accessible stockpile of savings. Most advisers say your fund should contain three to six months’ worth of salary. Others suggest that $2,000 to $3,000 is enough as long as you also have insurance to cover catastrophes. All experts agree, however, that a rainy-day fund should be used only for real emergencies. Unfortunately, not everyone has a rainy-day fund. A report from the Federal Reserve Board found that in 2017, 40 percent of Americans did not have the funds to cover an emergency expense of $400 without taking out a loan or selling something. Saving Can Help You Fund Your Retirement Have you ever considered what you will live on when you retire? At this point in your life, that question must seem like a remote concern. “First,” you might answer, “let me finish my education and choose a career.” Retirement is indeed a long way off. But in just a few years you will likely be working full time—earning, spending, and, if you are wise, saving. If you are really looking ahead, you will be saving for your eventual retirement. Americans today are living longer than ever before. Many people starting careers today will live for 20 or more years after they stop earning a paycheck. To maintain even a modest lifestyle during those years will take a lot of money. The earlier you begin accumulating that money, the more you will have when the time comes to retire. Most retired people support themselves using three sources of money, making retirement something like a three-legged stool. The three “legs” are Social Security, company retirement plans, and personal savings.

Social Security. Social Security is a government program that provides cash payments to retired workers. It is funded by taxes paid by workers and their employers. Social Security is a pay-as-you-go plan. This means that the Social Security taxes you pay each year are not saved for your future retirement. Instead, this money is paid out in benefits to current retirees. Company retirement plans. At one time, most large companies Level: A

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offered pension plans to their employees. A pension plan is a retirement plan to which the employer makes contributions for the future benefit of its employees. Today, the most common company retirement plan is the 401(k) plan. This plan gets its name from section 401(k) of the Internal Revenue Code—the main body of our nation’s tax laws. In a 401(k) plan, employees have money automatically taken out of their paychecks and put into retirement investment accounts. Employers may also contribute to the plan by matching all or part of an employee’s contribution. One benefit of a 401(k) plan is that participants may subtract their contributions from their taxable income when they file their tax returns. The effect is to lower the amount of income tax they are required to pay. Financial experts encourage all employees to put money into a 401(k) if their employer offers such a plan.

Personal savings. The third source of retirement funds is personal savings. Such savings may include a variety of financial assets, including private retirement plans—plans that are not employersponsored. An Individual Retirement Account is a private retirement plan sponsored by the federal government. Anyone who earns income can put money into an IRA. To encourage Americans to do so, the government has built tax advantages into IRA plans. Depending on the type of plan they choose, participants may either deduct the amount of their IRA contributions from their taxable incomes or take money out of their accounts tax free when they retire. For this reason, IRAs are often referred to as tax-sheltered savings accounts. IRAs, pensions, and other retirement plans come in many forms, each with its own set of rules. These rules govern such things as the amount you can contribute each year, how the account is taxed, and when you can begin to withdraw money from the account. Retirement savers should choose the plan that best suits their circumstances and meets their long-term goals.

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Figure 8.3B A budget is a plan that specifies how a person’s income will be allocated over a period of time. This budget reflects the saving and spending priorities of a young person who has completed school and joined the work force.

Creating a Budget with Saving in Mind A budget is a plan for spending and saving, based on one’s income and estimated expenses. It covers a specific time period, typically a month or year. For those who really want to take control of their day-to-day finances, making a budget is essential. The first step in creating a budget is to estimate your monthly income and expenses. This means keeping track of all income as well as all expenditures for a month. Figure 8.3B shows a typical budget for a young adult. It includes a mortgage or rent payment, a car loan payment or transportation expenses, as well as food, clothing, and other items. When most people construct a budget, they make the mistake of calculating only the cost of goods and services consumed. They subtract those expenses from their income, and what is left—if 2020 Teachers' Curriculum Institute

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anything—goes toward savings. To become a successful saver, however, saving needs to be an entry in your budget right from the beginning—perhaps even your first budget item. Setting aside money each month as savings might be difficult, but the effort will be well worth it. Nothing could be more important to your financial future.

4. How Do Americans Invest Their Savings? Learning how to save money for future use is an important first step in reaching your long-term goals. But saving alone is not enough. You will also need to learn how to invest the money you save. Investing involves using the money you have saved to earn even more money. Investing Offers Rewards—And Poses Risks People invest money in everything from rare coins to real estate because they expect a favorable financial return in the future. If you decide to invest in a college education, for example, you probably expect that your investment will improve your job prospects and future income. Likewise, when people invest in an old coin or a home, they assume that someday it will be worth more than they paid for it. The same holds true when people invest their savings in financial securities. Securities are investments that give their holders the right to receive some form of return, or profit. The two most common kinds of securities are stocks and bonds. People who invest in securities count on getting back the amount they invested plus interest or some other form of return on their investment. That return is their reward for making the investment. Not all investments, however, turn out as people hope and expect. Nearly every kind of investment involves some sort of risk. The price of rare coins or houses, for example, can go down as well as up. In general, there is a strong relationship between risk and reward. The higher the potential reward an investment offers, the higher the risk of losses rather than gains. In choosing what to invest in, therefore, it is important to weigh the various risks against the potential rewards. Investment Basics: The Power of Compounding You need not take great risks to ensure a safe return on your investments—if you are Level: A

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patient. You can invest your money conservatively and let the passage of time increase its value. The trick is to take advantage of the power of compounding. Compounding refers to the ability of an investment to generate earnings that can be reinvested to earn still more earnings. Banks make this happen when they offer to pay depositors compound interest, rather than simple interest, on their savings. Compound interest is interest paid not only on the original amount deposited in the savings account, but also on all interest earned by those savings. Compounding works like this. Suppose that on your 20th birthday you were to deposit $1,000 in a savings account that pays 4 percent compound interest once a year. In one year’s time, you would earn $40 in interest ($1,000 multiplied by 0.04). Rather than take your $40 out of the account to spend, you leave it there to compound. The account now contains $1,040. The next year, your savings account would earn 4 percent on $1,040— your original deposit plus the interest already accumulated. In that second year, you would earn $41.60 in interest, bringing the total in your account to $1,081.60. In reality, many banks compound interest on a daily rather than annual basis. That means you earn interest today on the interest the bank paid you yesterday. In the example above, the result of daily compounding would be to raise the rate of return on your savings to more than 4 percent. Rate of return is a measure of the change in the value of an investment over time. It is usually expressed as a percentage of value gained or lost in a year. Doubling Your Money: The Rule of 72 Suppose, now, you left your savings in the bank to compound year after year. In time, you would double your investment. But how long would this take? To find out, you could use the rule of 72 . This rule says to divide the number 72 by the annual rate of return on the investment. The answer is the number of years it will take to double the original investment.

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Government bonds are a safe investment. A bond is like an IOU with interest. It declares that the government will repay the amount of the bond at a certain rate of interest on a specific date. Bonds have sometimes been used to raise money during wartime, as this poster from World War I shows.

Using the rule of 72, you calculate that at a 4 percent annual rate of return, it would take 18 years for the $1,000 in your savings account to double to $2,000. In another 18 years, the account would double again to $4,000. By the time you reached the age of 74, your investment of $1,000 would have doubled yet again to $8,000. You would not have done a thing, yet you would have accumulated 8 times your original investment. Now consider what you would have at age 74 had you earned only simple interest on your account. Your $1,000 deposit would have earned $40 a year for 54 years, or a total of $2,160 in interest. Added 2020 Teachers' Curriculum Institute

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to your original $1,000, your account would total $3,160, much less than the $8,000 you would have earned by compounding. Compounding works not only for savings accounts, but for other kinds of investments as well. By reinvesting your earnings year after year, your investments can grow surprisingly fast. FDIC-Insured Savings and Government Bonds: The Safest Investments Fifty years ago, average Americans had relatively few ways to invest their savings. The $1,000 that you just turned into $8,000 would probably have been invested in a bank savings account. A savings account is still not a bad choice today, especially for people with a very low tolerance for risk. Bank deposits insured by the FDIC are among the safest investments you can make. Even if the bank loses all your savings, the FDIC—backed by the resources of the federal government—will reimburse you up to $250,000. Those who are reluctant to risk their savings might also choose to invest in government bonds. A bond is a loan in which the borrower promises to pay the lender a fixed rate of interest over the term of the loan and then repay the principal at the end of the term, or date of maturity. When you buy a bond, you are lending money to the issuer of the bond. You might think of a bond as an IOU that pays interest. The business of issuing and buying bonds takes place in the bond market. When the federal government needs to borrow money, it issues bonds. Known as U.S. Treasury bonds, they are the safest bonds a person can invest in, because the government can print money or raise taxes if needed to pay back the loan at maturity. Treasury bond terms range from 10 to 30 years. The federal government also borrows money by issuing Treasury bills and Treasury notes, which have shorter terms than Treasury bonds. Treasury bonds, bills, and notes all offer fairly low yields, or interest rates, but they are considered risk free. State and local governments also issue bonds to raise funds for public projects such as the building of schools, bridges, and highways. Known as municipal bonds, these securities are viewed as a bit riskier than Treasury bonds. They attract investors, however, because the interest earned on municipal bonds is exempt from federal income taxes. Nor is the interest taxed by the state in which the bond was issued. Corporate Bonds: Moderate Risk for More Return Level: A

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governments, corporations borrow money by selling bonds. Because corporations can, and do, go out of business, corporate bonds are riskier to invest in than government bonds. Should the corporation issuing the bond fail, the bondholders could lose some or all of their investments. Because of this higher risk, investors expect a higher rate of return on corporate bonds than on government bonds. The risk of buying a corporate bond varies according to the financial health of the corporation that issues it. To help investors assess that risk, rating companies examine bond issuers to evaluate their ability to repay their loans. High-quality corporate bonds are classified as investment grade. The ratings on these bonds range from AAA to BBB. Investment-grade bonds do not offer investors high returns, but the risk of the borrower failing to repay the loan is relatively low. For this reason, many people feel fairly safe investing in these top-rated bonds. Lower-quality bonds are classified high-yield or junk bonds . The ratings on these bonds range from BB to C. As the name high-yield suggests, these bonds offer higher potential returns in exchange for a moderately higher risk that the company might fail. Stocks: Historically the Highest Returns Bonds are debt-related securities. Stocks, in contrast, are securities that represent ownership in a business. When a company issues shares of stock, it is not borrowing money. Rather, it is selling ownership rights. The investors who buy the company’s stock become its shareholders. These shareholders own the company. As part owners of a company, shareholders have the right to receive a portion of the firm’s profits. That portion of profits is known as a dividend. Investors usually receive dividends in the form of a dollar amount for each share owned. To take advantage of the power of compounding, investors often choose to reinvest dividends, using them to buy additional shares of the company stock. The more shares an investor holds, the more dividends they receive. While many profitable companies pay dividends on their stock, many others do not. Instead they invest their profits back into the company to help it grow. Investors who buy non-dividend-paying stocks assume that the stock’s price will rise as the company grows, making their shares worth more over time. Historically, stocks have offered investors a higher real rate of return 2020 Teachers' Curriculum Institute

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than bonds. The real rate of return is the annual percentage return adjusted for the effects of inflation. During some periods, stock prices have marched fairly steadily upward. These happy times for stock investors are known as bull markets. At other times, stock prices have dropped just as steadily downward. These painful periods for investors are known as bear markets. Since 1899, bull markets have outnumbered and outlasted bear markets. However, past performance is no guarantee of future returns from stocks. Stock prices are variable. Even stable, well-managed companies can have bad years and see their stock prices plunge. Investors who want the higher returns that can be had by investing in stocks must also be willing to accept the higher risks.

Trading in the stock market takes place at a number of stock exchanges in major cities throughout the world. The oldest organized U.S. stock exchange is the New York Stock Exchange, shown here.

Investing in the Stock Market The most common way to buy and sell stocks is through a securities brokerage. A brokerage is a company that buys and sells stocks and bonds for investors. Brokerages employ stockbrokers to help investors make and carry out investment decisions. The actual buying and selling of stocks and bonds takes place in a stock market. The most famous stock market in the United States is the New York Stock Exchange, which handles the exchange of more than 2 billion shares of stock, on average, every trading day. Level: A

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To many Americans, the New York Stock Exchange is the stock market. But another exchange, the NASDAQ, also handles billions of shares per day. Many high-tech stocks are traded on the NASDAQ. The Securities and Exchange Commission, a federal agency established during the Great Depression, regulates the stock market. An important part of the SEC’s mission is to make sure all investors have access to the same financial information about firms issuing stock. Firms provide such information in a legal document known as a prospectus. A prospectus allows investors to make informed decisions about whether to buy or sell a firm’s stock. Investing in Mutual Funds Many Americans lack the time or interest to research which stocks or bonds to buy on their own. Instead, they invest in stock or bond mutual funds. A mutual fund is a collection of securities chosen and managed by a group of professional fund managers. Shares in a mutual fund can be bought and sold much like shares of stock. Mutual funds help investors to achieve diversification, or investing in a wide variety of financial assets. Investing in many stocks or bonds reduces the risk that a poor performance by any one asset will wipe out your savings. Every mutual fund is designed to achieve certain financial goals. Those goals vary from fund to fund, as do the risks and potential rewards. Stock funds typically emphasize growth and income from rising stock prices and dividends. Bond funds offer income at a lower risk than stock funds. Money market mutual funds behave much like bank savings accounts. They pay higher interest rates than most banks but are not insured by the FDIC. With some 10,000 mutual funds available, there is something for nearly every investor. An investor can tell how well a mutual fund is doing by comparing its performance against a broad market index. A market index measures changes in the value of a group of stocks, bonds, or other investments. The most often quoted stock index, the Dow Jones Industrial Average, was begun in 1896. The DJIA tracks the stock prices of 30 large U.S. corporations. The Standard & Poor’s 500 tracks the stock prices of 500 large firms traded on the stock exchange. Other indexes track different groups of securities such as foreign stocks and bonds.

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Figure 8.4 These graphs show how two investors might allocate their assets. The investors have the same goal—a comfortable retirement—but are at very different stages of life. The older investor is ready to retire now and can’t afford much risk. The young investor has 40 years to accumulate assets for retirement and can therefore afford a higher level of risk. An investor’s actual asset allocation would depend not just on age, but also on the person’s financial goals and risk tolerance.

Indexes tell investors how well the market for a class of stocks or bonds is doing as a whole. If a mutual fund consistently fails to match the overall returns of its market, investors may begin to question how well that mutual fund is being managed. Spreading the Risk Through Asset Allocation You may have heard the proverb “Don’t put all your eggs in one basket.” That old saying applies to today’s investors. Financial planners warn their clients not to invest all their savings in just stocks, just bonds, or any other single type of investment. The risk of that one investment losing money is simply too great. Instead, they advise following an approach to Level: A

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diversification known as asset allocation. Asset allocation involves dividing the assets in a person’s portfolio among different types of investment. The goal is to reduce the risk of investing while still earning good returns. Stocks, bonds, and cash are the three main asset categories. Cash here refers to assets that have fairly high liquidity, including savings deposits, CDs, and money market mutual funds. Asset-allocation decisions are personal. They depend on an investor’s age, risk tolerance, and financial goals. A young person saving for retirement, for example, can afford to risk more than a retired person. If one asset loses money, a young person has far more time to recover than a retiree who depends on personal savings for income. Figure 8.4 shows possible asset allocations for two people with the same goal—a comfortable retirement—but at very different stages in their lives. Ultimately it is up to you to decide how to spend, save, and invest your money. In making these decisions, the key to success is information. The better informed you are in money matters, the more likely you will be to make decisions that will enable you to live well today while still saving and investing for the future.

Summary Money serves many functions in a modern economy. People spend money to meet their daily needs. They also save and invest money to meet their future goals. What makes money . . . money? Money serves as a medium of exchange, a standard of value, and a store of value. To fulfill these functions well, what we use as money should have six characteristics: acceptability, scarcity, portability, durability, divisibility, and uniformity. Over time, money has evolved from commodity money to commoditybacked money to fiat money. Our money supply today, known as M1, is made up of currency and checkable deposits. How does the banking system work? As financial intermediaries, banks receive deposits and turn them into loans. Banks make a profit by charging borrowers more interest than they pay to depositors. The Federal Reserve determines the fraction of deposits that banks must keep in reserve. The Fed also provides services to banks, oversees and regulates banks, and controls the money supply. 2020 Teachers' Curriculum Institute

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Why is saving important to the economy—and to you? Savings provide money for loans that help businesses and the economy grow. Personal saving can also help you reach important financial goals, weather hard times, and fund your retirement. Creating a budget that includes regular saving can help you gain control of your finances. How do Americans invest their savings? Americans invest in a variety of financial assets, including savings accounts, government bonds, corporate bonds, stocks, and mutual funds. Each has its own level of risk and expected reward. Diversifying to balance risk and reward in a portfolio can be accomplished through asset allocation.

Money and the Future: A Cashless Society? Will cash go the way of the dinosaur? Might the growing popularity of other forms of payment—such as credit and debit cards and online banking—make cash extinct? Some people already argue that the penny, for example, should be retired from use, since it has little value in our modern economy. In fact, it costs more to make a penny than the coin is actually worth. Although it's hard to imagine, some people predict that the day will come when we no longer use currency as a medium of exchange. At that point, money would essentially be digital, stored in vast databases and accessed through electronic means. This essay considers how and why a cashless society might develop, and what its costs and benefits might be.

The Decline of Cash In the past few decades, monetary transactions in the United States and many other parts of the world have relied less and less on cash and more on electronic transfers of money. Banks and businesses of all kinds move vast sums by digital means, transferring money from one account to another without ever handling cash. The same is true for individuals. People make purchases and pay bills online. They shop with credit cards and debit cards, and have bill payments deducted automatically from their bank accounts. They use “smart cards” or “stored-value cards,” which contain microchips that can be loaded up with digital money. Smart cards are used just like Level: A

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cash to pay bridge tolls and fares on mass transit systems, to buy food at fast-food restaurants, and to make many other purchases. Even smart phones have the capability to act as a digital wallet. Although most people still carry cash, many find that paying for things with bills and coins is a bother.

The Benefits of Going Cashless One obvious benefit of going cashless is that shoppers no longer have to fumble with money when going through the checkout line. Paying is easier when you can just swipe your card through a machine. Many people also like to pay with “plastic”—credit cards and debit cards— because they get a statement at the end of the month that shows how they spent their money. In theory, such statements can help people manage their personal finances. Some advocates of a cashless economy even claim that eliminating cash will save businesses time and money and make the economy more efficient and productive. In 2007, the head of a major credit card company predicted that in a few years using credit and debit cards would be cheaper and more convenient than using cash. He said that retailers might eventually charge customers a fee for using cash because of the higher cost of processing cash payments. In many ways, his prediction was right. A 2016 Gallup Poll revealed that five years ago in 2011, 36% of Americans reported using cash for most of their purchases. In 2016, only 24% rely on cash, an indication of a switch to a more digital methodology.

The Costs of a Cashless Society Abandoning cash could also have its costs, however. As anyone who has ever bounced a check or run up a large credit card bill knows, it is easy to lose control over one's personal finances. Paying for things with cash helps restrain spending. When your wallet or pocketbook is empty, it's a clear sign that you should stop shopping. With a debit or credit card, however, you can always just “charge it” and ignore the consequences, at least for a while. Eventually, however, such habits can lead to empty bank accounts, large bills, and substantial finance charges. It's much easier to go into debt when you're not paying cash. There's another potential cost to a cashless society: a loss of privacy. Civil liberties experts warn that the widespread use of credit cards, smart cards, and other forms of “cashless commerce” gives businesses lots of data on consumer habits. They can then use these data to create 2020 Teachers' Curriculum Institute

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personal profiles of individual consumers. This may seem harmless, but it could have larger implications for society. Many privacy-rights advocates argue that the widespread use of such data could undermine our freedom.

Economic Inquiry: Financial Literacy Economic Inquiry: Financial Literacy You have just read about the structure and function of the banking system, and the importance of saving and investing money. Complete the open-ended inquiry below to further explore the importance of money in our society.

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Entrepreneurs and Business Organizations How do entrepreneurs use their resources to start businesses?

Vocabulary Glossary Vocabulary Cards sole proprietorship liability partnership corporation multinational corporation business franchise cooperative nonprofit organization

Introduction

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Entrepreneurs, and the businesses they start, play an essential role in the economy.

In the early 1970s, WLAC-TV in Nashville was looking for a new coanchor for a television news program. They hired a local talent, a young college student and former Miss Black Tennessee. No Nashville television station had ever featured an African American woman as news anchor before, and certainly no 19-year-old had ever coanchored the news, but the station decided to take a chance. In 1973, a young Oprah Winfrey made her television debut on Channel 5 news in Nashville. Winfrey was not a great success at reading the news, but she stuck with it, determined to have a career in television. Four years later, she moved to WJZ in Baltimore to coanchor the news there. Again, she struggled. She tended to get emotional and to stray from the script. Once she even cried on air. Winfrey was eventually taken off the news desk and given a morning chat show, People Are Talking, to cohost. After the first show, she told herself, “I’ve found what I was meant to do.” Winfrey’s relaxed, friendly Level: A

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on-air manner was a hit with viewers, and People Are Talking became the most popular talk show in the Baltimore market. The rest is history. In 1984, Oprah moved to Chicago and within two years was hosting the most-watched daytime talk show in the country. She also landed a role in the movie The Color Purple, for which she was nominated for an Oscar. By the late 1980s, Winfrey became one of the highest-paid performers in the entertainment industry. In 1988, Winfrey founded her own company, Harpo Productions, becoming the first African American woman to own a television studio. Her corporation has since grown to include magazine publishing and online media. Oprah Winfrey is not a typical entrepreneur. By the time she started her own business, she was already at the top of her industry. Her wealth and influence made it more likely that her company would succeed. By contrast, many entrepreneurs start from scratch, often borrowing money to start a business. Winfrey is one of millions of entrepreneurs driven by their dreams and talents to start their own businesses. In this lesson, you will read more about the vital role of entrepreneurs in business. You will explore the advantages and disadvantages of different types of business organizations, and you will look at the rights and responsibilities of owning a business, no matter what its size and structure.

1. What Does It Take to Start a New Business? Unlike Oprah Winfrey, Linda Alvarado faced considerable obstacles when she tried to start her own business. At 24, Alvarado had the skills, education, and experience necessary to start a company—but no money. In the 1970s, no bank would lend her the money to start a business as a woman breaking in to the male-dominated construction industry. Alvarado’s parents mortgaged their home so that they could lend her $2,500. In 1976, Alvarado founded Alvarado Construction. Her firm became one of the most successful construction firms in the country. How did she do it? “Perseverance and persistence have kept me going,” Alvarado says. Those qualities, among others, are what it takes to start a business. 2020 Teachers' Curriculum Institute

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The Essential Role of Entrepreneurs in Business Creation An entrepreneur is someone who takes on the responsibility and the risk of starting a business with the expectation of making a profit. Entrepreneurs come from every field of endeavor, and they play a critical role in the economy. By creating businesses, they meet consumer demand for goods and services, create jobs, and spur economic growth. Thomas Edison, for example, was not only a prolific inventor but also a brilliant entrepreneur. His genius lay in his ability to turn laboratory discoveries into practical inventions that people could use. Consider the use of electricity to light homes and businesses. Edison did not invent the first incandescent lightbulb, but he did invent the first long-lasting lightbulb that could be used indoors. He also designed the first central power station and, with it, a distribution system for bringing electricity into homes and offices. Edison thus created an entire industry out of a single invention. Mary Kay Ash, founder of Mary Kay Cosmetics, was a different kind of innovator. Ash wanted to tap into the entrepreneurial energy of women. In 1963, frustrated at the unequal treatment she received as a woman working in sales, Ash started her own company with a $5,000 investment. She bought the rights to special skin-care products and hired women to teach customers about the products, rather than pressuring customers to buy. Ash believed in “praising people to success” and rewarded her top saleswomen with pink Cadillacs. Her approach to business was unusual—and successful. At the time of Ash’s death in 2001, Mary Kay Cosmetics had made more than $1 billion in sales. Bill Gates, cofounder of Microsoft, was one of the first to see the enormous potential of the personal computer. In 1975, when Gates was 19 years old, he and his friend Paul Allen formed Microsoft and began developing software. Gates was certain that someday computers would be used in every home and office—and he wanted to be the one to put them there. For Gates’s visionary leadership in the information technology revolution, Time magazine named him one of the 100 most influential people of the 20th century. The Characteristics of Successful Entrepreneurs What do Linda Alvarado, Bill Gates, and Mary Kay Ash have in common? They share certain traits that helped them to succeed. Although there is no single personality profile of the successful entrepreneur, most of them possess the characteristics that follow. Level: A

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Ambition. Successful entrepreneurs are highly motivated people with the ability to see the big picture and to stay focused on the end result. They set goals for themselves and never stop striving to achieve those goals. Self-confidence. Successful entrepreneurs believe in themselves. They feel certain that they can accomplish what they set out to do. A willingness to take risks. Entrepreneurs are not afraid to risk their time, money, and energy on a new business idea. “The important thing is not being afraid to take a chance,” says Debbi Fields, the founder of Mrs. Fields Cookies. “Remember, the greatest failure is to not try. Once you find something you love to do, be the best at doing it.” Energy and self-discipline. Entrepreneurs are disciplined and thrive on hard work. “The first requisite for success,” said Edison, “is to develop the ability to focus and apply your mental and physical energies to the problem at hand—without growing weary.” Perseverance. Entrepreneurs do not give up. “When you reach an obstacle,” advised Mary Kay Ash, “turn it into an opportunity. You have the choice. You can overcome and be a winner, or you can allow it to overcome you and be a loser.”

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Figure 9.1A Entrepreneurs are innovators who create new businesses and even new industries. As this gallery suggests, they are often motivated by more than a simple desire to make money.

Problem solving ability. The ability to come up with solutions to problems marks all successful entrepreneurs. As Linda Alvarado put it, “I believe I will outwork most people in finding a solution.” Organizational skill. Most entrepreneurs own and operate their own businesses. Thus, the ability to manage time, resources, and people effectively and efficiently is critical to their success. “Good management,” said John D. Rockefeller, founder of Standard Oil Company, “consists in showing average people how to do the work of superior people.” Ability to motivate others. Entrepreneurs are good at inspiring others to join their team. “As we look ahead into the next century,” says Bill Gates, “leaders will be those who empower others.” Level: A

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The Risks and Rewards of Starting a Business Not everyone who sets out to be a business entrepreneur ends up a success. As Figure 9.1 shows, only about 48 percent of new businesses survive after five years of being in business. That means 52 percent of new start-ups—more than half—fail. “Once you’ve hit five years, your odds of survival go way up,” observes economist David Birch. “Only two to three percent of businesses older than five shut down each year.” The risk of failure is not the only challenge facing those who hope to become entrepreneurs. Raising money to finance a new business can be difficult, and new business owners are often beset by financial insecurity. Finding the right employees can also be a challenge. In addition, people who run their own businesses typically work long hours, often with little or no pay. Madam C. J. Walker, an African American founder of a hair-care product company and the first woman to become a millionaire, put it this way: “There is no royal, flower-strewn path to success . . . If I have accomplished anything in life, it is because I have been willing to work hard.” With all the drawbacks to starting a business, why would anyone want to be an entrepreneur? The answer lies in the incentives-matter principle. Running a successful business of one’s own can bring great rewards. The most obvious reward is the nearly unlimited potential to make money. Look no further than Oprah Winfrey and Bill Gates for proof of that. Yet, money is not the only factor that motivates most entrepreneurs. They simply love what they do. Says Winfrey, “I would do what I’m doing even if I weren’t getting paid.”

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Figure 9.1B Starting a new business is risky. As the graph shows, business startups have a high mortality rate. Of the new businesses started in 2008, fewer than half were still operating five years later. By 2015, the survival rate had dropped to 41 percent.

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Sole proprietorships are businesses owned and operated by one person. Many small businesses, like this record store, are organized in this way.

Part of the personal satisfaction of entrepreneurship comes from the freedom it affords. As a business owner, you are your own boss. You set your own hours, and you do what makes you happy. Entrepreneur Stephen Fairchild, for example, was always an avid spelunker, or cave explorer. In 1972, he sold everything he owned and quit his job to take over a company operating tours of Boyden Cavern, a cave in Giant Sequoia National Monument. He then went on to lead a company that owns other show caves and operates tours of a gold mine. “I take extreme pride in what I do,” Fairchild said, “but more important, I thoroughly enjoy what I do!” Many entrepreneurs also take satisfaction in knowing that they are contributing to the economy. New businesses can breathe economic life into depressed areas, creating new jobs and helping to support existing businesses. Successful business owners often become community leaders who invest in community projects and give to local charities. For Jerry Greenfield, cofounder of Ben & Jerry’s, a successful ice cream company, the chance to make positive change through business leadership was exciting. “We measured our success not just by how much money we made, but by how much we contributed to the community,” says Greenfield. “It was a twopart bottom line.”

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2. What Kinds of Businesses Are Best Organized as Sole Proprietorships? Businesses come in all shapes and sizes, ranging from small homebased businesses to huge companies with offices around the world. Economists categorize businesses based on how they are organized. Most U.S. business organizations fall into one of three general categories: sole proprietorships, partnerships, or corporations. The most common is the sole proprietorship, a business owned and managed by one person. Sole Proprietorships: One Owner, One Operator In a sole proprietorship, the owner of the business—the proprietor—earns all the profits and is responsible for all the debts. This form of business can be simple to establish and easy to manage, with relatively low start-up costs. This is the kind of business Timothy Redel chose when he started his photography business. Redel had traveled all over the world working as an assistant for other photographers before he went into business as a sole proprietor. To do so, he borrowed $10,000 from a bank. With these funds, he bought cameras and lighting equipment and set up shop, using his small apartment as a studio. He went on to become a highly successful photographer whose work has appeared in many national magazines.

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Figure 9.2 Sole proprietorships are by far the most common form of business in the United States. However, because sole proprietorships are typically small businesses, they generate far less revenue than large corporations do.

The ease of starting a sole proprietorship is probably why about 7 out of 10 businesses are organized this way. It is a form of business that appeals to people who have a marketable skill or trade and want to work for themselves rather than a boss. A sole proprietor might be a plumber, a pet sitter, a caterer, a farmer, a consultant, or an artist like Redel. Advantages of Sole Proprietorships For anyone thinking of starting a business, the sole proprietorship offers a number of advantages.

Ease of start-up. There is little paperwork involved in starting a sole proprietorship. Though requirements vary by city and state, the basics include: 2020 Teachers' Curriculum Institute

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obtaining a business license or business permit, a legal document that allows a business to operate in that state, city, or town. obtaining any necessary zoning permits. Local governments often designate certain areas, or zones, for specific business purposes. registering the business name. If a business carries the owner’s legal name—as in Timothy Redel Photography—this step is not necessary. If not, the proprietor must submit a “doing business as” form to the local government office.

Few restrictions. Sole proprietorships are the least regulated form of business. However, sole proprietorships still need to follow regulations in specific industries. For example, any business that serves food is subject to health department regulations. Full decision-making power. A sole proprietor makes all business decisions without having to consult with partners or shareholders. The freedom to make decisions quickly in response to market changes can be a great advantage for a business owner. Full profits and individual taxation. A sole proprietor keeps all the profits generated by the business after paying taxes. Sole proprietors pay personal income tax on their earnings. The business itself pays no taxes. Ease of closing. Sole proprietors can dissolve their businesses easily if they choose to do so. However, they must pay off business debts and taxes. Disadvantages of Sole Proprietorships Sole proprietorships, however, also have disadvantages. The following are the three main drawbacks of this form of business.

Unlimited liability. The legal obligation to pay debts is known as liability. Sole proprietors have unlimited liability, or full responsibility for paying any debts their businesses take on. If a business does not have enough assets to repay its debts, the owner must use their personal assets—such as a home, car, or bank account— to do so. Unlimited liability is the tradeoff a sole proprietor makes for having complete control and reaping all the profits. Many sole proprietors reduce their liability by organizing their business as a limited liability company. As in a sole proprietorship, the proprietor of an LLC pays personal income tax on the business’s profits. Level: A

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However, the proprietor’s liability is limited to whatever they have invested in the company. This advantage of LLCs has made them increasingly popular with business owners in recent years.

Limited growth potential. Because the success of a sole proprietorship rests on just one person—often a novice entrepreneur with limited assets— investors may be reluctant to lend money to a sole proprietor. Sole proprietorships can thus have difficulty obtaining the capital needed to expand. Business growth often depends on profits that can be reinvested in the enterprise. Limited life. A sole proprietorship almost always ceases to operate if the owner dies, goes bankrupt, or is unable to run the business for any reason. New management does not usually take over this type of business. This lack of permanence may discourage some people from seeking work in a sole proprietorship. It may also make lenders reluctant to make loans to businesses with a single owner.

3. What Kinds of Businesses Are Organized as Partnerships? 2020 Teachers' Curriculum Institute

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In 1988, brothers Wing Lam Lee, Ed Lee, and Mingo Lee decided to go into the restaurant business together. The brothers were surfers who had grown up in Brazil, had surfed in Mexico, and had worked in their family’s Chinese restaurant. All of these influences came together in their first restaurant: Wahoo’s Fish Taco in Costa Mesa, California. Wahoo’s featured a Mexican-Brazilian- Asian menu with grilled fish tacos as the specialty. The restaurant was so successful that by its 25year anniversary in 2013, the partners had opened more than 60 Wahoo’s restaurants. Partnerships like that of the Lee brothers are well known in the business world. Ben Cohen and Jerry Greenfield, friends since middle school, founded Ben & Jerry’s. Google, the internet search company, was founded by partners Larry Page and Sergey Brin. Partnerships are the second most common form of business organization in the United States.

These two women have opened up their own store together. This type of business is considered to be a partnership.

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Partnerships: Multiple Owners, Shared Profits A partnership is a business owned by two or more co-owners. Partners share profits from the business. They also share liability for any debts the business incurs. Familyowned businesses, small stores, farms, and medical practices are common examples of business partnerships. Law firms, accounting firms, and moneymanagement firms also frequently form partnership agreements. Partnerships may be formed by an oral agreement. However, the more common practice is to draw up a legally binding written agreement. There are different kinds of partnerships, each of which confers different responsibilities on the partners. The following are the three most common kinds of business partnerships:

General partnership. A general partnership is a form of business in which all co-owners have unlimited liability for any business debts. Additionally, owners, or general partners, are active in the operations of the business. Limited partnership. A limited partnership has at least one general partner and one or more limited partners. The limited partners contribute financial capital but leave day-to-day business operations to the general partners. For this reason, limited partners are also known as silent partners. The main advantage of being a limited partner is limited liability for debts owed by the partnership. Limited partners can lose only the amount of money they invested in the business should it be sued or go bankrupt. Limited liability partnership. In a limited liability partnership, coowners are allowed to operate like general partners while enjoying the protection of limited liability. An LLP is well suited to businesses in which all partners want to take an active role in managing the business. Professionals, such as attorneys, doctors, dentists, and accountants, often form LLPs.

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“Making partner” is the goal of many professionals who join a limited liability partnership. But becoming a partner is seldom as easy as this cartoon implies.

Advantages of Partnerships Like sole proprietorships, partnerships offer entrepreneurs a number of advantages.

Ease of start-up. Partnerships are relatively easy to establish. The same business permits that are required for a sole proprietorship are also required for a partnership. In addition, business and legal experts recommend that a legal agreement, known as articles of partnership, be drawn up. Articles of partnership usually specify each partner’s contribution in assets and labor. each partner’s share of the profits and losses. each partner’s authority and duties. how partners will settle disagreements. what happens in the event that a partner dies or leaves. how assets will be divided if the business fails. If articles of partnership are not drawn up, most states have guidelines regarding partner rights and responsibilities that automatically go into effect.

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regulations. However, like sole proprietorships, they must meet industry-specific regulations, such as health codes.

Shared decision-making power. “Two heads are better than one” is the philosophy guiding most partnerships. Partners can pool their experience and skills in making the decisions that guide the business. Specialization. Partners often bring different areas of expertise to a business. For instance, one partner may be good at managing people, whereas another may be a marketing whiz. Partnerships allow partners to do what each does best for the company’s overall benefit. Individual taxation. Partners share in the profits according to whatever arrangement they have made. Each partner pays income taxes on their share. The business itself does not have to pay taxes. Increased growth potential. People who go into business together each bring financial assets to the enterprise—their own assets as well as those of family and friends. Banks therefore see less risk in lending money to a partnership than to a sole proprietorship, which draws on the assets of just one person. For the same reason, suppliers are usually more willing to extend credit to a partnership because it is seen as a safer investment. With greater access to capital, partnerships often find it easier to expand their operations than do sole proprietorships. They are also better able to attract and hire talented employees, some of whom may aspire to become partners themselves someday. Disadvantages of Partnerships

Partnerships also have drawbacks.

Unlimited liability for general partners. Unless a partnership is a LLP, at least one partner—the general partner—has unlimited liability for debts. For example, should the business run into financial problems, general partners stand to lose not only what they have invested but also their personal assets outside of the business. Conflict between partners. Like any relationship, a business partnership has the potential for conflict. Partners who see eye to eye when they first go into business may come to disagree about management style, work habits, ethics, or the firm’s general goals and direction. Partnership agreements do not address such issues. Good communication and an honest effort to resolve conflicts are essential if a partnership is to survive. Continuity issues. Partnerships are a temporary form of business. If 2020 Teachers' Curriculum Institute

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one partner dies or decides to leave a partnership, the remaining partners will need to buy out the former partner’s share. The value of this share may be difficult or impossible to determine. Moreover, the remaining partners may not have the liquid assets needed to buy it. Survival may depend on finding a new partner with the financial resources to purchase the outgoing partner’s share of the business, which can be difficult.

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A stock certificate is a legal document that shows the number of shares of stock a shareholder owns in a corporation. This certificate indicates ownership of shares in Public Storage, the world’s largest operator of selfstorage facilities.

4. Why Are Large Businesses Organized as Corporations? Sometimes sole proprietors or partners realize that they need more financial capital to grow their businesses than they can provide on their own. One way to raise these funds is to seek venture capital. Venture capital is money from an individual investor or organization that invests in promising new businesses in exchange for a share of ownership. Another common way to raise money is to sell shares in the company to the public on the stock market. In either case, this is the time for the company to be reorganized as a corporation. Corporations: Ownership by Shareholders The word corporation has its roots in the Latin word corpus, which means “body.” The root of the word reflects the modern legal definition of corporation: a company treated under the law as a single body with its own powers, separate from its owners. A corporation has the power to enter into a 2020 Teachers' Curriculum Institute

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contract and buy and sell property, just as an individual does. Corporations are owned by shareholders who purchase shares of company stock. When a business becomes a corporation, it may offer for sale anywhere from several thousand to several million shares of stock. Such a stock offering might bring the company millions or even billions of dollars in new financial capital. Because of this opportunity, companies looking to expand might choose incorporation to create more possibilities for their business. Ben & Jerry’s offers a good example. Begun in 1978 as a partnership, the ice cream company became a corporation in 1984. That year, it offered stock to Vermont residents only, raising $750,000 for a new manufacturing facility. The following year, Ben & Jerry’s stock was offered for sale to the general public. Using the revenue from stock sales, the company expanded its operations, distributing its ice cream outside of New England for the first time. There are two kinds of business corporations. A privately held corporation is owned by an individual or a small group of individuals. It allows only a select group of people, often members of a family, to purchase stock. The stock is usually not for sale to the general public. A privately held corporation is also known as a closely held corporation. If a privately held corporation grows significantly, it may take steps to become, or may be sold to, a publicly held corporation. A publicly held corporation offers stock for sale to the general public and has many shareholders. This is the type of corporation Ben & Jerry’s became when it sold stock to the public. Stock in publicly held corporations is typically bought and sold through a stock exchange. How Corporations Are Organized Corporations all tend to be organized in much the same way. As shown in Figure 9.4A, the typical corporation is a hierarchy with different levels of employees. Every employee in a corporation reports to a higher-level employee. That person reports to an even higher-level employee, and so on. At the top of the corporate hierarchy sits the board of directors, which reports to the shareholders. A board of directors is a governing body that is elected by the shareholders. The board oversees management of the corporation. It also establishes corporate policy and makes sure that the company’s resources are being managed effectively.

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In many corporations, the board of directors is made up of “inside” as well as “outside” directors. An inside director is someone from within the firm, such as the company’s founder or a senior-level manager. An outside director is someone from outside the firm who can provide an independent perspective. One of the board’s most important responsibilities is to select the corporation’s chief executive officer . The CEO is the highest-ranking person in charge of managing a corporation. The CEO usually appoints other corporate officers—senior executives who oversee specific areas of the business. For example, the chief financial officer (CFO) is in charge of a company’s finances. The chief operating officer (COO) manages the day-to-day operations of a company. There are other departments that are typically operated by corporate officers, including marketing, legal, and information technology. These corporate officers, along with other senior executives, make up the senior management of a corporation. Reporting to them is a broad swath of managers known as middle management. This next level includes vice presidents, department heads, and managers of various ranks. Middle management is responsible for supervising the day-today activities of the firm’s workers. Advantages of a Corporation Businesses organized as corporations offer a number of advantages over sole proprietorships and partnerships.

Limited liability. A corporation’s owners—the shareholders—are liable only for the amount of money they have invested. For example, suppose an investor buys 100 shares of stock at $30 a share. If the corporation goes bankrupt, the investor will lose that $3,000 investment. Their personal assets are never at risk. The corporation is liable for its debts, however, because the law considers it a legal entity, like a person.

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Figure 9.4A The organization chart of a typical corporation is shaped like a pyramid. The CEO takes direction from the board of directors, which is elected by the shareholders. The employees are at the bottom. Managers at each level oversee the next level of workers below them.

Growth potential. Because corporations can use the sale of stock to raise financial capital, they have far greater potential for growth than do other forms of business. For example, Google offered stock to the public in 2004 in what is called an initial public offering. On the first day of Google’s IPO, 22 million shares were sold. This sale raised about $1.2 billion for the company. Professional management. Whereas sole proprietors and partners must manage their businesses themselves, corporations are run by professional managers. These managers often specialize in a particular area, such as finance or public relations. With this expertise, corporations can increase efficiency to a level that often is not possible in smaller organizations. Long life. Unlike sole proprietorships and partnerships, corporations continue to exist when founders die or owners sell their shares. As legal entities, corporations have permanence. For example, the company that became IBM Corporation was founded in 1888 and incorporated in 1911. Today, the corporation is one of the largest information Level: A

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technology employers in the world. This ability of corporations to continue indefinitely supports growth and long-range planning efforts. Disadvantages of a Corporation Although incorporation provides businesses with important advantages, it also has disadvantages.

Complexity of start-up. Businesses that want to incorporate are legally required to follow certain procedures. They must develop a prospectus. This document outlines for potential investors the main features of the enterprise and contains information about the stock being offered. They must apply for a business license. All states require new corporations to file a set of documents called articles of incorporation, also known as a corporate charter. A corporate charter details the company’s objectives, structure, and planned operations. It also specifies the number of shares of stock that may be issued. When state officials approve the charter, the company becomes a legal corporation. They must create corporate bylaws, or rules that govern the management of the corporation. Bylaws deal with such topics as how to conduct shareholder meetings, how to elect directors, what officers the organization will have, and what the duties of those officers will be. They must hold a meeting of shareholders to elect a board of directors. They must issue stock certificates to shareholders. A stock certificate is a legal document that certifies ownership of a specific number of shares in the corporation.

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Loss of control. Once a business has been incorporated, the role of the original owner or founder may change. Decisions once made by the founder become the responsibility of the board of directors and the professional management team. For the founder, the change usually means giving up some control of the company. More government regulation. Corporations are subject to more government regulation than are other types of businesses. For example, corporations are required to hold annual shareholder meetings. They must maintain detailed records of business transactions. Publicly held corporations must also file regular reports with the Securities and Exchange Commission, the federal agency that regulates the stock market. Double taxation. Corporations face heavier taxes than do sole proprietorships or partnerships. As legal entities, corporations are required to pay taxes on their profits. In addition, shareholders must pay income tax on any dividends they receive. Taxation at the corporate level and again at the shareholder level is known as double taxation. Multinational Corporations: Doing Business on a Global Scale Business enterprises that operate in more than one country—known as multinational corporations— are not new. Multinational corporations have existed since the 1600s, when English and Dutch trading companies first established outposts in the East Indies. Level: A

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However, in the past few decades, the number of global businesses has skyrocketed. In 1990, there were about 3,000 multinational corporations. Thirty years later, there were more than 80,000 parent corporations with over 800,000 affiliates around the globe. Most are smaller firms with fewer than 250 employees. Such corporations typically have headquarters in their “home” country and operate production facilities or deliver services in at least one other country. Each branch must obey the laws of the country in which it is located, including tax laws. Multinational corporations have advantages that other firms do not have. Their global reach gives them access to more markets, with greater potential for increased sales and growth. Access to multiple markets also makes it less likely that a multinational will go bankrupt. Moreover, multinational corporations often have access to cheaper labor and raw materials. For these reasons, the number of global corporations is likely keep growing.

Figure 9.4B In the past, most multinational corporations were based in Western Europe and North America. In recent decades, however, many Asian companies have gone global. The map shows the worldwide reach of LG Electronics, a multinational corporation based in South Korea.

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5. What Purposes Are Served by Franchises, Cooperatives, and Nonprofit Organizations? Not every business enterprise falls into one of the three business models described thus far. There are other types of business organizations that people adopt to achieve specific goals. One model is the business franchise. Business Franchises: One Parent Company with Many Outlets In a business franchise, a parent company grants to an independent business owner the exclusive right to use its trade name and sell its products in a designated location. This is the kind of arrangement that such companies as Holiday Inn, McDonald’s, and Dunkin’ Donuts use to distribute their products.

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Fast food locations, like the one pictured here, are often franchises. They are popular franchise options because the parent company usually has name recognition and a huge customer base.

Under a franchise agreement, a parent company, or franchiser, grants a license to operate an outlet in return for an initial payment and ongoing fees. The business owner who buys the license and distributes the franchiser’s products is the franchisee. The franchise model is well suited to businesses whose products or services can easily be replicated, or “cloned.” Motel rooms, hamburgers, and donuts are just such products. Franchise agreements are popular because they offer advantages to both the parent company and the local franchise owner. Franchising enables a parent company to expand rapidly and more cheaply than if it had to own and operate new outlets itself. At the same time, franchising gives people who want to own a business the opportunity to do so with some support. Franchisers help new owners get started with management training, budgets, and advertising campaigns. Moreover, many franchises have a record of profitability and a built-in customer base. For the would-be business owner, buying a franchise may be less of a financial risk than starting one’s own business. There are also disadvantages to franchising. Franchisers charge high fees for the right to use their name. The bigger the name, the more expensive the franchise rights. Franchisees must also pay royalties, or a percentage of earnings, to the parent company. These costs are on top of the usual costs of operating a business. 2020 Teachers' Curriculum Institute

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In addition, being a franchise owner means giving up some independence. Franchise agreements usually require franchisees to follow strict rules and procedures. For some aspiring entrepreneurs, this lack of independence may be a big drawback. Cooperatives: Share Ownership for Shared Benefits Another popular form of business organization is the cooperative, or co-op for short. A cooperative is a business that is owned and operated by a group of individuals for their shared benefit. Cooperatives are businesses, but with some important differences. Coops are not in business to make a profit. Rather their goal is to meet their members’ needs for affordable goods and services. Co-ops are run democratically, with members electing other members to a board of directors. Many people who join co-ops are consumers looking to increase their buying power. Consumer co-ops sell goods to their members at reduced prices. They can do this because they purchase bulk quantities at a lower cost. The requirements of membership in a consumer co-op vary. Some co-ops require members to work a certain number of hours, whereas others require a yearly membership fee. Food co-ops, housing cooperatives, and discount price clubs are types of consumer cooperatives. Other kinds of consumer co-ops provide services instead of goods. Such services include health care, childcare, and insurance services. Credit unions, or financial cooperatives, make low-cost loans to their members. Electric cooperatives, found mainly in rural areas, provide low-cost electricity to their members. In 2017, electric co-ops delivered electricity to 42 million Americans. Producers also form cooperatives. The most common producer cooperative is the agricultural co-op, also known as a farm organization. Some agricultural co-ops function like consumer co-ops, providing farmer members with lowcost seeds and equipment. Other agricultural co-ops help to market and sell members’ products. Some well-known food brands, such as Sun-Maid, Land O’ Lakes, and Ocean Spray, are agricultural co-ops. Ocean Spray, the producer of juice drinks, is owned by over 700 cranberry and grapefruit growers in the United States and Canada. Nonprofit Organizations Yet another common business model is the nonprofit organization. A nonprofit organization functions like a business, except that it does not operate to make a profit. Instead, nonprofits are established to support particular public or private goals. Human rights, the arts, the environment, religion, and medical research Level: A

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are just a few of the areas in which nonprofits are active. Nonprofits range from global organizations like the Red Cross to local soup kitchens and animal shelters, as you can see in Figure 9.5. Although some nonprofit groups are organized informally, many seek nonprofit status from the federal government. Nonprofit organizations may be tax exempt, which means they are not required to pay income tax. However, taxexempt nonprofits are limited to how much income they can earn and how they may use their earnings. Most groups are funded, at least in part, by donations. A nonprofit may be organized in a variety of ways: as a corporation, a cooperative, a trust, or a foundation. Conservation nonprofits are often organized as land trusts. For example, the Nature Conservancy is a land trust that works to protect wilderness areas and waterways around the world as nature preserves. A foundation is an organization that is created and supported by donated funds or property. Foundations are often created by people who have made fortunes in business. Bill and Melinda Gates, for example, created a foundation dedicated to “bringing innovations in health and learning to the global community.” Since its founding in 1994, the Bill and Melinda Gates Foundation has given billions of dollars to groups working to improve health care and education in developing countries and in the United States. Other kinds of nonprofit organizations support the interests of businesses and professional people. A business association represents the interests of businesspeople in a geographical area. Such organizations often go by the title of Chamber of Commerce. A trade association represents the interests of people working in a particular industry. Trade associations include groups like the Alliance of Automobile Manufacturers and the Motion Picture Association of America. Such groups use advertising, education, and political lobbying to promote their interests.

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Figure 9.5 Nonprofit organizations are active in many fields. However, the majority of people employed by nonprofits work for organizations that provide health care services.

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Uber, the popular ridesharing company, came under scrutiny after it was discovered that it covered up a hack of its customers’ and drivers’ data. What responsibilities did the corporation have in regards to securing its data?

People who work in a profession, such as medicine or teaching, often join a professional organization. These nonprofits establish standards of training and ethics for professionals in their fields. They also work to improve conditions for people in their profession. The American Nurses Association, for example, represents 4 million registered nurses. It promotes the rights of nurses in the workplace and lobbies Congress on health care issues that affect nurses. Labor unions are organizations of workers in a specific industry. A labor union seeks to improve working conditions, wages, hours, and benefits for its members. Labor unions are active in a wide range of industries. Actors, miners, police officers, and aerospace workers, for example, are all represented by unions.

6. What Rights and Responsibilities Do Businesses Have in a Free Enterprise System? 2020 Teachers' Curriculum Institute

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In 2016, Uber, the transportation company, suffered a massive data breach. During this breach, hackers accessed and stole the personal information of about 25 million customers and drivers in the United States and an additional 32 million more people globally. In response, Uber paid the hackers $100,000 dollars to delete the data they acquired, which included names, emails, phone numbers, and license numbers. At first, Uber did not tell its users or drivers about the data breach. When the breach was revealed a year later, however, it caused an uproar. Uber fired the employees who were involved in the payment, and the company’s CEO issued an apology. Meanwhile, attorneys general across the country filed a lawsuit alleging that Uber violated laws by not informing consumers that their information had been compromised. As part of the suit’s settlement, Uber was ordered to pay out $148 million. It also faced fines in other countries, including the United Kingdom and the Netherlands. The Rights of Businesses Uber’s security missteps raised an interesting question: What rights do businesses have when it comes to information about their customers? In a free enterprise system, businesses clearly have many of the same rights that individuals have. These include the right to own property and the right to enter into and enforce contracts. The text below lists five other specific rights of business.

The right to advertise. The First Amendment’s guarantee of freedom of speech did not originally protect the right of businesses to advertise. In recent decades, however, courts have ruled that advertising is “commercial speech.” As such, it is protected under the Constitution. With certain exceptions, such as ads for alcohol and tobacco, the government places few restrictions on how companies can market their products.

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Figure 9.6 Businesses use a variety of symbols to identify and protect their intellectual property. The most important are illustrated here.

The right to hire and fire employees. Most states have “employment at will” regulations that protect a business’s right to hire or fire employees as its needs change. They also protect an employee’s right to quit a job for any reason. The main exception to this rule is when a contract exists between a business and an employee. Unless the contract states otherwise, the employee cannot be fired until the contract ends. The right to screen employees. Businesses have a legal obligation to provide a safe workplace for their employees and clients. To do so, they have the right to perform background checks on job candidates as well as drug testing on job applicants and employees. The right to be fairly compensated for property. The Fifth Amendment prohibits the government from taking private property for public use without paying a fair price for it. This right to fair compensation applies to businesses as well as individuals. It ensures that business owners and shareholders will not lose their investment should the government need to take over their property. The right to protect intellectual property. Businesses are free to 2020 Teachers' Curriculum Institute

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use patent, copyright, and trademark laws to protect their exclusive rights to intellectual property. A trademark is a distinctive name or symbol that identifies a firm and its products or services and that has been legally registered as the property of that firm. Other forms of protected intellectual property include trade secrets, company logos, designs, and inventions. In short, any intellectual product that has commercial value qualifies as protected intellectual property. The Responsibilities of Businesses The list of rights does not answer the question raised by Uber users about the data breach and how Uber’s response put their private information at risk. Nonetheless, the users who expressed concerns and the attorneys general who filed suit clearly felt that Uber had a responsibility to act on their privacy concerns. Businesses, like individuals, have many responsibilities. Some are based on our expectations about how a business should behave. Other responsibilities are defined and enforced by law.

Obtaining licenses and permits. Businesses must obtain all licenses and permits required by law. For example, a business that uses or stores hazardous materials is required to get a fire department permit. People practicing certain trades or professions, such as plumbers, electricians, and doctors, must be licensed. Such regulations are intended to ensure public safety. Paying taxes. Business owners are responsible for paying all taxes that apply to their businesses. These may include income, sales, and property taxes. Businesses that do not pay their taxes are subject to penalties and fines. Dealing honestly. Businesses have a responsibility to deal honestly with their customers and suppliers. Businesses that intentionally misrepresent facts, conceal information, publish false or misleading ads, or otherwise try to cheat people are committing fraud. Business fraud is against federal and state law and is subject to prosecution. Honoring contracts. Businesses, like individuals, may choose whether to enter into a contract. However, once entered into, a contract is legally binding. Businesses thus have an obligation to honor their contracts with customers, suppliers, and others. When a contract is broken, the injured party may take legal action.

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Though companies aren’t required to give to charity, many choose to do so. In 2017, Google provided nearly $255 million dollars to charitable organizations.

Creating an equal opportunity workplace. Federal law requires businesses to treat all employees equally. Discrimination on the basis of race, gender, age, ethnicity, religion, or disabilities is illegal. Companies have a responsibility to make sure their employment practices—such as hiring, firing, pay, and promotions —are nondiscriminatory. Protecting whistle-blowers. An employee who reports an employer’s misconduct to legal authorities is known as a whistle-blower. In the past, whistle-blowers were often fired for speaking out. However, federal and state laws now protect them from such retaliation. Ensuring product safety. Businesses are responsible for making sure the products they sell are safe. Federal and state laws govern product safety. When a product is found to be unsafe or defective, the manufacturer may be held liable for any harm it may have caused. It Is Legal—But Is It Ethical? In our free enterprise system, businesses are legally permitted to do a great many things. Cosmetics companies may test products on animals. Farmers may use pesticides on crops. Retail stores may pay wages that are too low for employees to live on. But does that mean businesses should do these things? On the other hand, there are a great many things that are not required by law—such as giving to charity. But does that mean businesses should not do them? As these questions imply there is often a difference between what is legal and what is ethically or morally right. This distinction lies at the 2020 Teachers' Curriculum Institute

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heart of the growing corporate responsibility movement. Corporate responsibility is the idea that businesses should take responsibility for the impact of their actions on society. It requires looking beyond a firm’s responsibility to its shareholders and considering the needs of its stakeholders. A stakeholder is anyone who has an interest in, or is affected by, a company’s actions. Stakeholders include employees, customers, suppliers, competitors, and the community in which the business operates. A growing number of businesses are striving to be good “corporate citizens” by considering the interests of stakeholders. Stonyfield Farm is one example. This organic yogurt manufacturer gives 10 percent of its profits to groups that work to protect the environment. Many companies address issues of corporate responsibility by creating codes of business ethics. Business ethics are principles of right and wrong that guide the actions of a company and its employees. Visualscope Studios, a company that provides web design and search engine services to businesses, created the code of ethics below.

We treat our clients and web site visitors with honesty and respect at all times. We honor and respectfully exercise any authority and/or privileges provided to us by our clients. We will be upfront with our rates and fees from the project initiation, so you will be clear on what our roles and expectations are. We will maintain a high level of competence, as well as staying current with new trends in the web design and development industry. We will always work to the best of our abilities to ensure the timely delivery and success of every web project. We will protect sensitive information given by clients and customers as private and confidential.

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Companies may promote their dedication to corporate responsibility on their products to attract consumers. This ketchup bottle, for example, shows the company's dedication to using plant-based and recyclable materials.

Are ethical business practices important to Americans? The answer seems to be “yes.” A 2015 report found that 63 percent of American consumers felt that business ethics were becoming increasingly important. The report also revealed that 56 percent of American consumers will stop buying products from a company they believe is unethical. Around one-third of consumers stated they would stop buying products from unethical companies, even if there was no available substitute. Studies have shown that ethical business practices are important to clients and consumers. In addition to appealing to clients and consumers, businesses with a reputation for high ethical standards and social responsibility may have an edge when it comes to attracting a talented and local workforce. This could give them a competitive advantage in the market. At this point in your life, business ethics are probably not something you need to think much about. But as you move into the world of work, that may change. Later on, you will explore the business world from the working person’s perspective. You will also learn about human capital, the labor market, and how you might fit into the labor market one day.

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Entrepreneurs are the hardworking visionaries who create new business enterprises. Such enterprises may be sole proprietorships, partnerships, corporations, business franchises, cooperatives, or nonprofit organizations. What does it take to start a new business? The qualities needed to succeed in business include creativity, determination, and energy. Starting a business is financially risky, but success offers rewards, including unlimited earning potential and a sense of accomplishment. What kinds of businesses are best organized as sole proprietorships? Sole proprietors tend to be people with a marketable skill who want to work for themselves. They reap the profits and are liable for debts. Small businesses and farms make up the majority of sole proprietorships. What kinds of businesses are organized as partnerships? In a business partnership, two or more owners share profits and liability. Such businesses may be organized as general, limited, or limited liability partnerships. Family-owned businesses, law firms, and medical practices are common examples of partnerships. Why are large businesses organized as corporations? The corporation is well suited for a large business because it can sell stock to raise financial capital, thus allowing for growth. It is a legal entity independent of its owners—the shareholders—and can thus exist indefinitely. What purposes are served by franchises, cooperatives, and nonprofit organizations? Business franchises allow a franchiser to create a distribution network at low cost, while providing business opportunities to franchisees. Cooperatives provide benefits to their members. Nonprofits pursue particular public or private goals but do not operate to make a profit. What rights and responsibilities do businesses have in a free enterprise system? Businesses have the legal right to advertise, to hire and fire, to screen employees, and to protect intellectual property, among other rights. Legal responsibilities include obtaining licenses and permits, paying taxes, honoring contracts, and using nondiscriminatory employment practices. Many companies have established ethical codes of conduct to guide their actions.

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Economic Information and Advances in Technology Information is one of the keys to making good economic decisions. Wise consumers, for example, research a product or service before buying it. Advances in technology have increased the amount and types of economic information available to households, businesses, and government. This essay gives some examples of economic information available to these three groups as a result of technological innovations.

Information for Households Advances in computer and Internet technology have given American households much greater access to information about goods and services. Consumers with a computer and Internet service can go online and find out much of what they need to know before making a purchase. Increasingly consumers also shop online, buying everything from clothing and household goods to airline tickets and automobiles. Many households also use computers to help them make financial decisions. They can get information about loans and interest rates online. They can do banking and pay their bills over the Internet. Many investors use financial Web sites to monitor their investment portfolios and to research stocks and bonds. With the click of a mouse, they can buy, sell, or transfer financial assets online. All these consumer conveniences are a direct result of advances in technology.

Business Innovations Technology has also helped businesses gather information on consumer preferences, develop marketing strategies, and boost their economic efficiency. Many retail outlets and online businesses use sophisticated technologies to track consumer spending habits. With these data, they can present consumers with product information tailored to their individual preferences. That approach can be seen in retail web sites that recommend specific purchases to consumers based on their buying history. Those same kinds of consumer data are also used to develop marketing strategies that help companies increase sales. Advances in communications and information technology have helped companies gather economic data and do business more efficiently. A company with national or international operations can maintain close 2020 Teachers' Curriculum Institute

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contact with its branches, clients, and customers through satellite technology and videoconferencing. It can research foreign markets, adjust inventories, and take orders with greater speed and efficiency. In this way, technological innovations have sped up the process of globalization.

Government Data New technology has also helped government agencies gather, analyze, and distribute economic information. Powerful computers and advanced software programs allow for more sophisticated economic analysis. The government can track employment figures, consumer spending, tax revenues, and other economic data more efficiently. It can monitor the economy more closely and make more accurate predictions. This information helps economists and government officials evaluate programs and develop economic policy. Government data also help businesses and households make economic decisions and plan for the future. Much of this information has been generated and made available through technological innovations.

Farm Organizations: History, Goals, and Impact Farm organizations in the United States arose to address the problems and needs of American farmers. This essay examines the development and impact of American farm groups.

Farmers Get Organized Until the mid-1800s, the U.S. economy was based mainly on agriculture. Most farmers worked on small family farms. That picture began to change as the country industrialized and westward expansion opened up new lands for farming. Farm size increased and farmers used railroads to ship their goods to market. They also began to use more farm machinery. Farm output grew and the supply of food soon exceeded demand. As a result, crop prices fell. The price of a bushel of wheat declined from $1.45 in 1866 to 80 cents in the mid-1880s and 49 cents by the mid-1890s. At the same time, shipping and equipment costs were rising. Farmers took out loans to cover their costs but couldn't earn enough to pay their debts. As their problems mounted, many farmers became desperate. They began to organize to improve their economic conditions. Level: A

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In 1867, Midwestern farmers formed the Grange, the first major farm organization. Local chapters soon opened throughout the Midwest and South. By the mid-1870s, the Grange had more than 850,000 members. It taught self-reliance and thrift, urging farmers to avoid debt. It set up its own cooperative stores and grain elevators (buildings for storing grain) to cut costs. It also lobbied state legislatures to pass “Granger laws” that set limits on railroad shipping rates. When the Supreme Court struck down some of these laws, Congress stepped in and agreed to monitor the railroads. Through the Interstate Commerce Act, Congress established the principle of federal regulation of interstate transport. Despite some success, the Grange movement soon lost strength. It failed to defeat the railroad interests or solve farmers' financial problems. In the end, it dropped its economic goals to focus on social and educational services. But its efforts paved the way for a new and more aggressive farmers' movement. This movement, called the Farmers' Alliance, arose in the late 1870s. Conditions were still difficult. In the South, many farmers lost their land and became tenant farmers or sharecroppers. They rented land from landowners and paid with cash or a share of the crops. On the Great Plains, many farmers remained in debt to banks, equipment dealers, and railroads. The Alliance movement spread throughout the South and into the Plains states. Millions of farmers eventually joined three separate branches of the Farmers' Alliance. Like the Grange, the Alliance formed cooperatives and provided educational services. But it also engaged in political action. It held rallies and protests. It called for currency reform and a new type of government credit for farmers. It also worked for the election of public officials. By 1890, the Alliance could claim the support of several governors and nearly 50 members of Congress. In 1892, the separate branches of the Farmers' Alliance merged to form the Populist Party. The Populists ran candidates in state and national elections, including three presidential elections. They never had great political success, but they did manage to achieve some of their reform goals, including regulation of railroads and a system of agricultural credit.

The Organizing Continues Farmers continued their organizing efforts in the early 1900s. They formed two groups, the National Farmers Union and the Farm Bureau 2020 Teachers' Curriculum Institute

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Federation. Both organizations promoted education and legislation to benefit farmers. For a brief period, farm conditions improved. But they took a sharp turn for the worse in the early 1930s with the start of the Great Depression. Again, high production and low demand caused crop prices to plummet. In 1932, farmers in the Midwest organized a movement called the Farmers' Holiday Association. This group tried to boost prices by “taking a holiday” and holding farm products off the market. They even dumped thousands of gallons of milk in protest. Responding to the farmers' plight, President Franklin D. Roosevelt approved New Deal legislation designed to raise crop prices. This law, the Agricultural Adjustment Act, paid farmers not to plant crops in order to reduce supply. This was the first in a number of federal laws over the years that have provided agricultural subsidies to farmers. The government also eased credit for farmers to help them pay their debts. During the Depression, poor farmers in the South formed the Southern Tenant Farmers Union. The STFU united black and white tenant farmers, sharecroppers, and farmworkers. It protested abuses by landowners and went on strike for better pay and working conditions. The federal government responded by forming the Farm Security Administration, which provided loans to poor farmers to help them buy land. In 1946, the STFU was renamed the National Farm Labor Union and became part of the American Federation of Labor. Although it never achieved its economic goals, the STFU did sow the seeds of interracial cooperation in the South. In 1962, another group, the United Farm Workers, began to organize farmworkers in the Southwest. These workers, most of them Mexican or Mexican-American, toiled for low wages and under poor conditions. Led by its founder, Cesar Chavez, the UFW organized strikes and consumer boycotts to force growers to the bargaining table. As a result, farmworkers got higher pay and better working conditions.

Farm Organizations Today Today, the UFW continues its work of organizing and representing farm labor. Other groups, such as the National Farmers Union and the Farm Bureau, also continue their educational and political work. Another group, the National Farmers Organization, markets farm products for its members and tries to negotiate the best possible prices. Farm organizations work with members of Congress to pass legislation Level: A

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that benefits farmers and farm communities. Among other things, these groups try to ensure that the government maintains farm credit and crop subsidy programs that are critical to the economic well-being of farmers. They also take positions on other economic and political issues that affect farmers and the nation as a whole.

Starting and Operating a Business Many people dream of starting their own business. They may have a product or service they would like to sell. Or they may simply like the idea of working for themselves. Whatever they have in mind, most entrepreneurs follow certain basic steps in starting and operating a business. These steps include planning and setting up the business and producing the goods or services. Other basic steps include marketing, finance, and assessment.

Planning a Business The first step in planning a business is to recognize opportunities. A business can only succeed if it meets a demand in the marketplace. It must offer a product or service that people want to buy. Entrepreneurs research the market and analyze consumer demand. They evaluate their competition. If opportunities exist, entrepreneurs can go forward with their business idea. Entrepreneurs also set goals for their business. For example, they must consider how big they want the business to be. Do they want to limit sales to a local or national market? Or do they also want to export to foreign markets? Building an export business can increase sales, but it also entails higher transportation and distribution costs. These factors must be considered carefully in setting goals for the business. The next step is to create a business plan. This explains what the business will produce, where it will be located, and how it will operate. It lists the goals of the business and tells how they will be achieved. If the business is small, the plan can be relatively brief. If the business is large, it will probably be long and detailed. A typical business plan includes the following information: • description and goals of the business • market analysis and growth potential 2020 Teachers' Curriculum Institute

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• organization and management structure • marketing and sales strategies • financial details Entrepreneurs may use a business plan to secure funding for their business. The plan should give investors or lenders a clear idea of the proposed business. It should help them evaluate the business and judge its chances for success.

Producing Goods or Services With a business plan in place, the production phase can begin. Production involves many different steps. Some of these steps must be taken before anything is actually produced. For example, if the idea is to create a new product, then product development is necessary. Depending on the product, this step might require a lot of research, time, and money. The business may also need to acquire office or factory space. It may need to buy equipment or machinery for use in production. Employees may need to be hired. The company must also acquire the raw materials or components used in production. As production gets underway, the supply and distribution of these materials must be regular and reliable. Many businesses will have to consider how they will dispose of waste products or materials created during production. Record keeping is important, too. All the quantities and costs of materials must be recorded for accounting and tax purposes and to ensure compliance with government regulations. Once the goods are produced, they must be delivered. This requires the creation of a distribution network, which might include truck, train, or air transport. It might also require warehouses to store goods on their way to market. The business must manage its inventory—the goods it has in stock—to ensure that it has enough products to supply its customers.

Marketing, Finance, and Assessment No business can survive without selling its goods or services. To that end, businesses must develop a marketing strategy to increase sales. They must analyze the market and develop effective ways to promote their products. Advertising is often a key element of marketing. Continued financing is also critical. Most businesses hope to earn enough profit to finance their current operations or future growth. But in many cases they must also rely on loans or investment capital to Level: A

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stay on track. They may also need to sell land or other business property that is not providing a good return on investment. Although it can be difficult to dispose of property or look to outside funding, sound finances and money management are keys to a healthy business. Finally, all businesses must regularly assess their progress. Are they meeting the goals laid out in their business plan? Are they using their Is their marketing strategy effective? These and other questions are part of the ongoing assessment process that businesses must follow if they are to succeed in a competitive market.

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Human Capital and the Labor Market Why is it important to develop your human capital?

Vocabulary Glossary Vocabulary Cards labor force offshoring equilibrium wage fringe benefits wage gap affirmative action collective bargaining right-to-work law

Introduction

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Human capital plays a critical role in the labor market.

Each year, millions of high school students choose to enter the workforce. Some get summer jobs to earn extra spending cash before college begins in the fall. Others get jobs to help support their families. Some begin careers in an industry right after high school ends. But how do these high school students acquire jobs? For most, job searching is a difficult and time-consuming process. Hopeful applicants must build and edit resumes, write cover letters, and prepare for interviews. They also must focus on a primary goal: making themselves stand out. But how can one applicant stand out in a labor market of almost 140 million people? In recent years, social media has changed the ways in which applicants can stand out. Not only must applicants prepare a resume and cover letter, but they must also curate a professional online presence. Recruiters and hiring managers often use the internet to look up job applicants and see if they could be a good fit for their companies. Education and skills also help an applicant to stand out. For high school students, some employers may consider school grades or extracurricular activities in the hiring process. High school students can bolster their education background by taking extra classes or attending Level: A

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college to further their skills in a particular area. Once a standout applicant has been hired, they will likely start work in an entry level position. From there, they will accumulate new skills and build their experience in a specific field. In turn, this will increase their ability to stand out in future job searches. In this lesson, you will read about trends that are shaping the labor market today. You will also learn how you can develop your own human capital as you prepare to enter the workforce.

1. What Trends Are Shaping Today’s Labor Market? Before social media platforms became massively popular, few people would have believed that someone could make money from simply spending time on an app like Instagram. However, many people have done just that. The technology that makes Instagram possible has opened networking and career opportunities that have never existed before. New technology has often been a driving force behind changes in the job market, creating new jobs even as it makes others obsolete. But changing technology is just one of many trends that have helped to shape the U.S. labor market in recent decades. A Larger, More Diverse Labor Force One long-term trend has been the steady growth of the nation’s labor force, which has increased along with the nation’s population. The labor force consists of those people age 16 and over who have jobs or who are actively looking for work. The labor force does not include unpaid workers, such as stay-at-home parents and volunteers. Nor does it include active members of the military or prison inmates. In 2018, the U.S. labor force included over 163 million people. A key reason for this growth has been the increased participation of women in the workforce. In 1960, when many women worked as homemakers, women made up 33 percent of the workforce. As women increasingly sought jobs outside the home, that figure rose. By 2018, women made up 47 percent of the labor force. Figure 10.1A shows the percentage of working-age women in the labor force over the span of a half-century. 2020 Teachers' Curriculum Institute

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Figure 10.1A This graph shows the labor force participation rates for men and women since 1960 and projected to 2025. The labor force includes the portion of the population that is working or looking for work.

Members of minority groups have also joined the workforce in growing numbers since 1960. In 1980, Latinos made up only 5 percent of the labor force. This number more than tripled by 2018, when Latinos comprised 18 percent of the labor force. Older Americans will also remain an important part of the working population over the next decade. Although some will begin to retire over this time period, many are expected to extend their working lives beyond the traditional retirement age of 65. In contrast, the labor force participation of younger Americans has been slowly decreasing. The main reason for this decline is increased college enrollments. Rather than going directly into the workforce, many high school students are now choosing to continue their educations. A Shift from Manufacturing to Service Jobs The number of workers involved in the production of factory goods has declined. At the same time, the number of workers who provide services has increased. Jobs in the service sector include food preparation, banking, and health care. Level: A

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This shift toward services continues a long evolution that began with the Industrial Revolution. By the late 1800s, manufacturing was replacing farming as the nation’s most important economic activity. Manufacturing dominated the economy through most of the 1900s. Beginning in the latter half of the 20th century, however, businesses that provide services have become the major source of jobs and economic growth. Economists expect this trend to continue. Figure 10.1B shows how the shift to service jobs is likely to affect future employment opportunities.

Figure 10.1B This graph shows how job opportunities are expected to grow (or shrink) in various occupations. Service occupations include jobs that directly assist the public such as police officers, health care aides, and cooks.

The fact that fewer Americans work in manufacturing these days does not mean that factory output is declining in this country. Just the opposite is true. Since 1970, the United States has been one of the 2020 Teachers' Curriculum Institute

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world’s largest producer of manufactured goods. American-made products range from industrial machinery to motorcycles to T-shirts. Because of gains in productivity, fewer workers are needed to turn out all these goods. Workers today are better educated and trained than they were a generation ago. Businesses have invested in labor-saving technologies, such as computers and robots. Since 1987, labor productivity in manufacturing has increased every year. Factory workers have traditionally earned higher wages than most service workers. But this does not mean that all service jobs pay low wages. In fact, the service sector includes professional fields such as law, medicine, and information technology. In these fields, the most qualified and experienced workers command high salaries. The Bureau of Labor Statistics, which tracks employment trends, predicts that jobs in the service sector will continue to expand. Figure 10.1C shows the 20 fastest-growing occupations based on BLS projections, most of which are service jobs.

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Figure 10.1C This graph shows the 20 fastestgrowing occupations by 2020 as identified by the Bureau of Labor Statistics. Note that most of these fast-growing jobs are in the service sector.

The Growing Importance of Knowledge Workers Another key trend in the labor market is the growing need for knowledge workers. Management consultant Peter Drucker coined this term in 1959 to describe people who work with information or who develop or apply information in the workplace. Financial advisers, for example, develop information when they analyze stock market returns. They apply that knowledge when they provide investment advice to clients. Knowledge workers are a subset of workers in the service sector. They include people who work in the information technology field, such as computer programmers and systems analysts. Writers, researchers, teachers, lawyers, and scientists are also knowledge workers. The demand for knowledge workers is expected to grow as the handling of information becomes an increasingly important part of the economy. 2020 Teachers' Curriculum Institute

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Increased Outsourcing, Temping, and Telecommuting Another set of trends in the labor market has to do with changes in the way people work. Many people spend less time working at the office and more time working at home than they did a decade ago. They also change jobs more frequently than was the case for previous generations. One key development in recent years is the growth of outsourcing. This term refers to the business practice of sending work once done by company employees to outside contractors. Firms decide to outsource work when they believe an outside supplier can do the work more efficiently and at a lower cost than can be done within the company. For example, a medical practice might decide to outsource its billing operations to a firm that specializes in medical billing. Similarly, a school district might decide to outsource its legal work to an outside law firm. Outsourcing generates work for independent contractors. It may also result in the loss of jobs for in-house employees. The use of temporary workers is also common. Temp workers are employed for limited periods of time for a variety of reasons. They may be hired for a project, to fill in for a sick or an absent employee, or to augment a firm’s workforce during a busy time. People choose temp work for many reasons. Many enjoy learning new skills as they move from one job to the next. Others value the flexibility they have in deciding who to work for and when. They also like being able to take time off for any reason at any time without asking anyone’s permission. Temps are generally paid as well as or better than permanent employees doing the same job. And some view temping as a good way to try out a job before joining a firm as a regular employee. Telecommuting is another growing practice in the labor market. Telecommuters do much or even all of their work at home, using phones and computers to remain connected to their workplaces. Telecommuting is especially common among knowledge workers. Writers, for example, can deliver drafts of their work by email without ever stepping into their employer’s office.

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Some companies choose to set up factories overseas in order to produce their goods for less money. This shoe factory in Thailand will produce goods that will then be sold to other countries around the world.

The Globalization of Work: Offshoring, Inshoring, and Foreign Competition Globalization is yet another trend that is transforming the labor market. Globalization is the process by which people around the world, along with their economic activities, are becoming increasingly interconnected. As globalization increases, the factors of production—land, labor, and capital—move across borders with greater ease than ever before. One key aspect of globalization is the growing practice of offshoring, or relocating work and jobs to other countries. Offshoring occurs in two ways. An American firm can either move part of its operations to a facility it sets up in another country or contract with a company in another country to handle some aspect of its operations. Firms move work offshore to reduce costs. The sportswear company Nike, for example, contracts with factories in more than 40 countries, including Vietnam and China. These are countries where Nike can achieve higher output for every dollar it spends on labor than it can in the United States. Charles Wheelan describes why companies may choose to offshore in his book, Naked Economics: Undressing the Dismal Science. As Charles Wheelan explains,

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There are industries in which American workers are not productive enough to justify their relatively high wages, such as manufacturing textiles and shoes. These are industries that require relatively unskilled labor, which is more expensive in this country than in the developing world. Can a Vietnamese peasant sew basketball shoes together? Yes—and for a lot less than the American minimum wage. Offshoring is also occurring in the service sector. Many computer programming and call-center operations, for example, have been offshored to India. With a large number of well-educated, Englishspeaking workers available at relatively low wages, India has a comparative advantage in these services. Moving work offshore has both costs and benefits. It lowers the cost of production of many goods. This translates into lower prices for American consumers. The tradeoff is a loss of jobs in some sectors of the economy. Globalization also brings jobs into the U.S. labor market. Many foreign firms have opened operations in this country. They do so to take advantage of the high levels of human capital available here. This process, known as inshoring, creates jobs for American workers. As globalization increases, American businesses will face growing competition from foreign producers. This competition may cause job losses in some U.S. industries, but it will also create new jobs in others. Looking at the big picture, economists argue that foreign competition is good for businesses and economies. It forces producers to become more competitive by developing their own comparative advantages.

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Figure 10.2A Competition for apple pickers helps determine market wages. The same is true in other competitive labor markets.

2. What Determines How Much Workers Earn? When you receive a job offer, the company that wants to hire you suggests a salary that you are free to accept or reject. How does the company decide how much to offer? How do you decide whether the offer is fair? Both questions can be answered by looking at the wage rates for other, similar positions in the job market. In general, wage rates are determined by the same principle that determines the price of Level: A

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goods and services: supply and demand. Wages Reflect the Value of What Workers Produce A number of factors influence wage rates. One has to do with the skills and training required for a job. Economists categorize jobs according to four general skill levels.

Unskilled. These jobs require no specialized skills or training. Most workers at this level earn a low hourly wage. Examples of unskilled jobs include janitors, busboys, and seasonal farmworkers. Semiskilled. Workers at this level have some specialized skills and training, including the ability to use simple tools or equipment. Employees are supervised, and wages are paid on an hourly basis. Jobs include cashiers, construction workers, taxi drivers, and fast food cooks. Skilled. This level requires specialized skills and training. Workers need little or no supervision, but most are still paid on an hourly basis. Examples include police officers, carpenters, bank tellers, and factory workers who operate complicated machinery. Professional. This level includes “white collar” jobs that require advanced training and specialized skills. Many professional workers receive a salary. Jobs include doctors, lawyers, teachers, airline pilots, and computer specialists. In general, wages are based on skill level. As skills and training increase, so do wages. More importantly, however, workers command wages that reflect the market value of what they produce. Surgeons are paid more than nurses, for example, because the market places a higher value on surgery than it does on general nursing care. Competition among employers to hire workers also helps to raise wages. Figure 10.2A illustrates this point by looking at the effect of competition on wages for apple pickers. In this scenario, Farmer A begins the harvest season by paying his apple pickers $7.00 an hour. Farmer B, faced with a shortage of workers, decides to offer $8.00 an hour. Lured by the higher wages, a number of workers leave Farmer A and go to work for Farmer B. As a result of this competition for workers, Farmer A must also raise wages in order to attract and retain new workers. nursing care. For the same reason, those who are perceived to be more productive workers tend to receive higher wages than those viewed as less productive workers. As economist Robert Frank notes, “Workers tend to 2020 Teachers' Curriculum Institute

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be paid in rough proportion to the value they add to their employer’s bottom line.” How Demand and Supply Work in the Labor Market Farmer A and Farmer B illustrate a real dynamic that shapes the labor market: the interaction of supply and demand. Employers create the demand for labor, and workers seeking jobs create the supply. Wages move toward equilibrium in the labor market just as prices move toward equilibrium in the market for goods and services. The demand for labor comes from businesses and government agencies that compete with each other to hire workers. Demand changes over time with the state of the economy. When the economy is doing well, the quantity of labor demanded goes up, and just as an increased demand for goods tends to raise prices, an increased demand for labor tends to boost wages. In the case of Farmers A and B, competition for apple pickers forced wages up. Conversely, wages tend to fall when the supply of labor increases or the demand for labor decreases. When the number of people seeking jobs exceeds the quantity demanded, employers can offer lower wages and still find people who are willing to work. Immigration can play a role in increasing the labor supply and lowering wage rates. In recent decades, competition for jobs from new immigrants has helped to depress wages at the lower end of the labor market. That is one reason why many less skilled workers oppose increased immigration. The labor supply is also affected by the tradeoff between work and leisure. When wages are low, people may be less inclined to work and more inclined to pursue other activities. When wages are high, however, workers tend to sacrifice leisure activities in favor of work. In making such decisions, people are following the costs-versus-benefits principle. For example, suppose you plan to spend time with your friends one afternoon when a neighbor offers you a job cleaning her garage. If she were to offer $5 for an afternoon of work, you would probably say no. But if she were to offer $100, you would probably take the job. In this case, the benefit of earning $100 would outweigh the cost of not seeing your friends. Over time, wages tend to move toward equilibrium. An equilibrium wage is a wage rate that results in neither a surplus nor a shortage of qualified workers. Level: A

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If the wage for a job is too high, a surplus of workers will apply for the job and employers will lower the wage. If the wage is too low, too few people will apply, and the wage will have to rise to attract more workers. Only when the wage reaches equilibrium will demand and supply be in balance. The graphs in Figure 10.2B show equilibrium wages for two occupations: lawyer and security guard. The wages for these jobs differ for two main reasons. First, the skill level and training required of lawyers is much greater than that required of security guards. Lawyers invest a great deal of time and money in their education. Therefore, the supply of lawyers is smaller than the supply of security guards. The second reason is that lawyers perform a higher-value service than security guards do. People are willing to pay more for a lawyer than a security guard. Since the lawyer’s labor is more highly valued, the labor warrants a higher wage.

Figure 10.2B When wages reach equilibrium, the number of people willing to work at that wage equals the number of people that employers are willing to hire at that wage. That equilibrium point is generally higher in occupations that require extensive education and training. • Note that the supply of lawyers is low relative to demand, which drives wages up. • The supply of security guards, in contrast, is high relative to demand, which pushes wages down.

Other Factors that Affect Wages Other factors can also affect wages, including minimum wage laws, working conditions, and cost of living. 2020 Teachers' Curriculum Institute

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Minimum wage laws. Minimum wage laws passed by the federal and state governments can raise wages for low-skill jobs above the equilibrium level. State minimum wage rates vary and may differ from the federal rate. Most workers qualify for the minimum wage, but exceptions exist. Workers who do not qualify include people who are self-employed, such as babysitters, and the employees of very small businesses. Around half of all Americans who earn the federal minimum wage or less are young workers under the age of 25. Working conditions. Jobs with working conditions that are uncomfortable, stressful, or dangerous may also pay higher wages than less-demanding jobs at similar skill levels. For example, Alaskan crabfishing crews earn more than fishing crews elsewhere, in part because working conditions are so dangerous in the seas off Alaska due to storms or freezing temperatures. Similarly, air traffic controllers work under highly stressful conditions and receive relatively high wages to compensate for that stress. Location and cost of living. In some parts of the United States, employers may be willing to pay extra to attract qualified workers. A rural hospital, for example, may pay doctors more than a city hospital because the remote location limits the supply of doctors. The cost of living in a region also affects wages. Living costs in California, for example, are much higher than in Florida. Wages in these states reflect this difference. For example, mechanical engineers in California made an average of around $94,000 in 2017 compared to just under $75,000 for mechanical engineers in Florida.

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Crab fishing is one of the most lucrative but dangerous jobs in the world. Violent winter storms and subzero temperatures make working conditions perilous. To compensate for these dangers, Alaskan crab-fishing crews earn higher wages than those who fish in less hazardous waters.

Rising cost of fringe benefits. The cost of fringe benefits also affects wages. Fringe benefits are nonwage compensations offered to workers in addition to their pay. Typical benefits include health insurance, paid vacation time, and retirement plans. The cost of such benefits has risen in recent years. Health insurance in particular has become increasingly expensive. In 1999, employers nationwide spent an average of $4,247 on private health insurance per worker with a family coverage plan. In 2018, employers spent over $14,000 on average. These rising costs have helped to depress wages in some industries, as employers compensate for high health care costs by holding down wages.

Foreign competition. Competition for jobs in the global market also helps to depress wages. As more companies offshore key tasks to lowwage countries, wage rates in the United States face downward pressure. For example, many American furniture manufacturers now offshore production to low-wage countries such as China. Faced with factory closings, furniture workers in the United States may agree to accept lower wages in order to keep their jobs. The Wage Gap and Affirmative Action 2020 Teachers' Curriculum Institute

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also been influenced by discrimination against certain groups in society. Wage discrimination occurs when some workers are paid less to do the same job as other workers because of their ethnicity, gender, or other personal characteristics. The Civil Rights Act of 1964 outlawed discrimination based on gender, race, religion, and country of origin. Nevertheless, a wage gap—a difference in the wages earned by different groups in society—still exists. For example, since 1964, the wage gap between men and women has narrowed, but women on average earn only about fourfifths of what men earn. In 2018, the median weekly income for men working fulltime was $973. For women, the figure was $789. Research shows that a gender-based wage gap exists within different racial and ethnic groups: Asian Americans, whites, African Americans, and Hispanics. There is also a wage gap between these racial and ethnic groups, with Asian Americans earning the highest median salaries and Hispanics the lowest. Economists attribute some of the wage gap to measurable factors, such as difference in educational attainment. However, studies show that discrimination still exists in the labor market. Many economists contend that the remedy for this problem is market competition. They argue that firms that discriminate will not be able to compete in the long run because they do not take advantage of the whole pool of qualified workers. Therefore, firms that do not discriminate will be more profitable than those that do.

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Many jobs come with benefits in addition to a salary or wages. Such benefits usually include health insurance and paid vacation time. The rising cost of benefits is squeezing employers, who may compensate by holding down wages—or even, as this cartoon implies, rolling them back.

Nevertheless, there are limits to the power of market forces to end discrimination. The United States has antidiscrimination laws to help fill the gap. Affirmative action initiatives are also intended to prevent discrimination. These initiatives call on employers to take positive steps to increase the presence of historically underrepresented groups in employment, education, and business. Affirmative action policies have aroused controversy. Critics argue that affirmative action creates a type of reverse discrimination, or claim that it creates a racial quota. Supporters, however, do not view affirmative action efforts as reverse racism; they believe that these efforts promote racial diversity and equal opportunity. In a series of landmark cases, the U.S. Supreme Court has narrowly upheld affirmative action in such areas as college admissions. Still, the debate continues as to whether affirmative action is the appropriate means to achieve equal opportunity for all.

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3. How Can You Increase Your Human Capital? Though it may not seem like it, you can take a major step towards a career in photography if you have an Instagram account. The skills you develop on social media can expand your human capital and eventually lead to a steady job. Developing one’s human capital is the key to success in the job market. But how does a person go about doing that? The Starting Point: Aptitudes, Interests, and Aspirations Developing your human capital is a lifelong pursuit. It continues as long as you are expanding your skills, experience, and knowledge. The first step in building your human capital is to identify your aptitudes, interests, and aspirations. In other words, think about what you are good at, what you like to do, and what you hope to accomplish in your working life.

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This assessment can only be done through honest self-evaluation. It is important to be realistic about your skills and abilities, but it is also important to pursue your dreams. It is not always easy to assess yourself. Fortunately, there are some tools that can help. Career counselors can offer useful advice and help steer you in the right direction. Many self-help books focus on helping readers to find and develop a career path. Aptitude tests and skills inventories can also help you analyze your abilities and interests.

All states require certification or a license to practice certain professions. After graduating from nursing school, this registered nurse had to pass a national licensing exam to get a job. Licensing exams help ensure that people in certain professions are competent in their fields.

Becoming Qualified: Education, Certification, and Licensing Education is one of the main routes to developing human capital. A good general education gives you many tools for success in the working world. A more advanced education will help you progress even further. There are many ways to advance your education beyond high school. Besides the traditional four-year college or university, there are community colleges, technical institutes, job-training programs, and online courses. Higher education may also qualify you for certification or licensing to practice a particular profession. Certification is an official recognition that a person is qualified in his or her field. In some professions, 2020 Teachers' Curriculum Institute

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certification is required by law. Teachers, for example, must be state certified to teach in public schools. Doctors must pass state licensing exams to practice medicine. In other fields, certification is voluntary. However, certification is usually recommended as a way for aspiring professionals to show their competence and commitment to their field. Education will also help you earn more money. The difference in wages paid to high school and college graduates has grown over the years. In general, wages are rising faster for more educated, more skilled workers than for less educated, less skilled workers. In 1979, people with college degrees earned 134 percent of the wages of people without degrees. By 2016, this gap had widened further, increasing to 168 percent. The value of a college degree is increasing for several reasons. As U.S. businesses seek a comparative advantage in the global economy, the demand for well-educated knowledge workers is growing. Many employers believe that a college education makes workers more productive. Others see a college degree as a sign of motivation and general ability. Either way, a college degree serves as a screening device that employers can use to identify high-value employees. Gaining Work Experience and On-the-Job Training Another way to build your human capital is through work experience and on-the-job training. When hiring new workers, employers often look for people who have significant experience and have developed useful job skills. The importance of work experience explains why wages tend to rise the longer a person has been in the labor force. Of course, getting a job can be difficult when you lack work experience in the first place. But it is not impossible. Some employers prefer to hire people they can train on the job. A restaurant, for example, might hire a cook trainee who would start out doing low-level kitchen tasks. Over time, a cook trainee would learn how the kitchen works and how to prepare items on the menu. For a trainee who is dependable and willing to work hard, on-the-job training can be the first step on a career path. Another way to get a job when you have no experience is to seek out an entry-level position in a field that interests you. Typically, entry-level jobs—such as office assistant and sales assistant—do not pay much. But they can provide valuable experience and allow you to start building a work history. By starting at the bottom, you show your willingness to work and to gain the experience and skills you need to move up the job ladder.

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Increasing Personal Productivity: Effort and High Standards The level of energy and enthusiasm that workers bring to a job also increases their value to employers. The workers who stand out are often those who make the greatest effort and hold themselves to the highest standards. An employer may respond to an employees efforts and enthusiasm with a pay raise or promotion. In some jobs, workers are rewarded based on how much they produce. This is true in many sales jobs, for example, where people work on commission and earn a percentage of everything they sell. Other jobs may pay year-end bonuses or offer salary increases based on worker productivity. In either case, workers enhance their job opportunities by making the effort to work hard and excel at what they do. Building a Personal-Professional Network People can also develop their human capital by building a personal-professional network of friends and colleagues. One way to do this is to join a professional association, labor union, or other type of occupational group. Belonging to such a group can help people develop work contacts and create a sense of community in their chosen field. Other ways of building a personal-professional network include getting involved in community affairs, volunteering, or participating in a local sports team. Such activities help people expand their connections within the community. These connections can have positive effects on their working lives by creating new job contacts and new opportunities for professional growth. They may even lead to more job opportunities in the future.

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4. What Role Do Unions Play in the Labor Market? On the first Monday in September, many of us attend picnics and other events associated with Labor Day. The roots of this holiday go back to 1882, when labor organizers in New York City held a parade to celebrate the role of workers in American life. The celebration became an annual event and soon spread to other cities. In 1894, Congress passed a law making Labor Day an official national holiday. The Origins of the Union Movement Labor Day owes its existence to the union movement, which began in the late 1800s. At the time, many U.S. workers suffered from harsh working conditions in factories and mines. They worked long hours for low pay, often in unhealthy or dangerous circumstances. If workers complained, they were likely to be fired. In response, workers formed unions to help protect their interests. These early unions were relatively small and lacked the power to negotiate with factory owners. Level: A

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In the late 1800s, however, small unions began to join together to form larger labor federations. The first such federation was the Knights of Labor. Founded in 1869, it brought together both skilled and unskilled workers. The Knights of Labor soon faced competitors. One was the American Federation of Labor. The AFL concentrated mainly on organizing skilled workers. Another was the Industrial Workers of the World. The IWW sought to unite all workers, both skilled and unskilled, under the motto “an injury to one is an injury to all.” Speaking for their members with one voice, union leaders bargained with employers for better pay and working conditions. If negotiations failed, unions called on workers to strike. During a strike, workers refused to work until their demands were met. Employers fiercely resisted the union movement. Some used their influence with government officials to block union organizing. Others required employees to sign yellow-dog contracts , which prohibited workers from joining unions. Employers responded to strikes by hiring strikebreakers to force the strikers back to work.

The Golden Age of Labor Unions Despite setbacks, the union movement continued to grow for several decades. During the Great Depression of the 1930s, unions enjoyed their greatest success under the New Deal policies created by President Franklin D. Roosevelt. At the president’s urging, Congress passed the National Labor Relations Act in 1935. Also known as the Wagner Act, this law guaranteed workers “the right to self-organization, to form, join, or assist labor organizations, [and] to bargain collectively through representatives of their own choosing.” The law also permitted closed shops. A closed shop is a business that will only hire workers who are union members. Gaining the right to “bargain collectively” was a breakthrough for unions. Collective bargaining is a process in which workers, represented by their union, negotiate with employers for better wages 2020 Teachers' Curriculum Institute

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and working conditions. The Wagner Act required employers to bargain in “good faith.” The Wagner Act ushered in a “golden age” of labor unionism. During this period, union membership increased and workers enjoyed rising pay and benefits. Encouraged by such success, several large unions came together in 1938 to form a new labor federation, the Congress of Industrial Organizations. The CIO would later merge with the AFL to create the AFL-CIO. By the late 1940s, however, many in business and government felt that the Wagner Act had gone too far in empowering labor unions. In 1947, Congress passed the Taft-Hartley Act to rein in the unions. This law outlawed the closed shop and placed limits on the power of unions to organize and strike. It did, however, allow union shops. In a union shop, workers are required to join the union after being hired. The Taft-Hartley Act also permitted states to pass right-to-work laws. These laws make it illegal to require workers to join a union as a condition of their employment. In effect, right-to-work laws ban the union shop. Currently there are some 20 right-to-work states. Most are located in the South and West. Supporters of these laws believe that people should have the right to choose whether they join a union or not. But opponents believe that it allows some workers to benefit from union led progress, such as higher pay, without contributing to the union itself. The Modern Union Movement Despite the restrictions of the TaftHartley Act, the number of union members continued to increase into the 1970s. Union membership peaked at more than 22 million in 1975. But by then union membership had begun to decline. In 1970, one out of every four American workers belonged to a union. By 2018, that number was about one in ten. The profile of union members has also changed since the 1970s. A generation or two ago, the typical union member was a factory worker. Today, as the bar graph in Figure 10.4 shows, that worker is more likely to be a government employee, such as a teacher or a police officer, than a factory worker. Economists cite a number of reasons for the drop in union membership. One is the loss of manufacturing jobs and the rise of service industries. Historically, service workers have been difficult to organize. In addition, the government now guarantees many of the rights unions once had to fight for, such as workplace safety and an eight-hour workday. Also, Level: A

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changes in law have made it easier for employers to win concessions from unions. Employers may threaten to outsource jobs, for example, rather than concede to union demands. In a bid to reverse the downward trend in union membership, seven major unions representing 6 million members broke away from the AFLCIO in 2005. They then joined forces to create the Change to Win federation. This new labor federation is largely made up of servicesector unions that represent female, immigrant, and minority workers. Despite the formation of Change to Win, union influence appears to be continuing its decline. States are increasingly turning to legislation to try to limit the power of unions. Legislators in Michigan, traditionally a state with a strong union presence, passed right-to-work laws in late 2012. This legislation could prove to be yet another blow to the already declining labor movement. Bread-and-Butter Unionism Today: Wages, Benefits, and Job Security To expand union membership, Change to Win is concentrating on bread-and-butter unionism. This means focusing on the economic issues that affect workers’ daily lives. Change to Win summarizes these issues as “a paycheck that can support a family, affordable health care, a secure retirement and dignity on the job.”

Figure 10.4 As the line graph shows, the percentage of American workers who belong to unions rose and then fell over the past century. The circle graph shows the percentage of union members employed in various parts of the economy in 2017. 2020 Teachers' Curriculum Institute

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Unions often lead strikes when they believe that working conditions are unfair or unhealthy. After negotiations about breadand-butter issues like a livable salary broke down between union leaders and the Oakland Unified School District, union members organized the strike pictured here.

By focusing on these bread-and-butter issues, unions perform a vital function for many American workers. They work to secure better pay and improved benefits for their members. They try to save workers’ jobs when companies engage in outsourcing and offshoring. They provide information to workers about their rights as employees. Some unions provide training to help workers improve their job skills. By helping to build human capital in this way, unions not only provide benefits to their members, but also to the organizations that employ them. This brings us back to the question we began with: Why is it important to develop your human capital? The answer is both simple and complex. Human capital is one of the most important factors that determine a worker’s value in the labor market. But human capital is not a simple set of skills. It also encompasses aptitudes, knowledge, experience, motivation, energy, and attitude. As you prepare to enter the labor market, remember that your human capital is your most valuable resource. The more you develop it now, the more success you will enjoy in the world of work.

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Summary Changes in the labor market are having an effect on the jobs and wages available to American workers. As the labor market evolves, it becomes more important than ever for workers to develop their human capital. What trends are shaping today’s labor market? An influx of women and minorities has changed the labor force in recent decades. In addition, job growth has shifted from manufacturing to the service sector, and knowledge workers have become increasingly important. Globalization is also having an impact as foreign trade and competition have increased both the offshoring and inshoring of jobs. What determines how much workers earn? Wage rates reflect various factors in the labor market. Wages primarily depend on the skill level of workers and the value of what they produce. Like the price of goods and services, wages are set by supply and demand. Wage rates move toward equilibrium as the demand for workers with the skills needed for a given job and the supply of such workers come into balance. What can you do to increase your human capital? The first step to increasing your human capital is to identify your abilities, interests, and goals. After that, get the education you will need to meet any licensing or certification requirements. Other key steps include gaining work experience, holding yourself to high performance standards, and building a network of friends and colleagues. What role do unions play in the labor market? Historically, unions have helped workers defend their rights and improve their pay and working conditions. Although union membership has declined in recent decades, unions today are still helping many workers achieve concrete gains in the workplace.

International Labor Issues: Worker Exploitation and Immigrant Labor The growth of the global economy has had an impact on labor conditions both at home and abroad. This essay examines two issues 2020 Teachers' Curriculum Institute

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related to international labor. It looks at the problem of worker exploitation in poor countries, focusing on concerns about child labor and sweatshop industries. It also considers the issue of immigrant workers and their impact on the labor market in the United States.

Worker Exploitation: Child Labor and Sweatshops Historically, workers around the world have often had to work long hours, in unsafe conditions, for low pay. Labor unions were formed to address this problem and protect the rights of workers. In richer, developed countries with a history of union organizing, workers have generally improved their pay and working conditions. However, in poorer, developing nations, where unions are often weaker, workers may still be severely exploited. Concerns about exploitation often focus on child labor and sweatshop industries. In some parts of the world, child labor is very common. According to UNICEF, the United Nations Children's Fund, 158 million children between the ages of 5 and 14 are engaged in child labor. That's one in every six children around the world. They work in mines, in textile mills, as domestic servants, and in many other occupations. They may be forced to work by their parents or other adults. The work is often hard and the conditions abusive. In some cases, this work takes place in sweatshops. These are small factories, workshops, or assembly plants where workers must put in long hours for low pay and often under hazardous conditions. In a typical sweatshop, workers have few rights and little chance of improving their wages or work environment. Some people fear that globalization is contributing to worker exploitation. As businesses move from richer countries to poorer countries to take advantage of lower wages and other cost savings, they may be adding to problems of child labor, sweatshops, and other forms of exploitation. In opinion polls, a majority of Americans say they want to see higher labor standards enforced for foreign workers. They say they do not want to buy products produced in sweatshops or made by child workers. At the same time, some economists contend that child labor and sweatshops would not exist if people weren't willing to take the jobs. They point out that workers in poor countries often find sweatshops an improvement over working in agriculture, mining, or various other occupations. By providing employment, even at low wages, sweatshop industries may offer workers in poor countries better opportunities than Level: A

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they would otherwise have.

Immigrant Workers and the U.S. Labor Market Another international labor issue involves immigrant workers in the United States. Although some immigrants have legal work visas, others do not. Most undocumented workers enter the country illegally, usually by crossing the border from Mexico. Some Americans contend that undocumented immigrants harm the U.S. labor market by increasing competition for jobs and lowering wages for American workers. Others argue that immigrant workers bring large benefits to the U.S. economy. Though making such estimates is difficult, between 9 million and 20 million undocumented immigrants live in the United States. Most of them are here to find work. Many are unskilled and are willing to work for relatively low pay. For that reason, and because they increase the labor supply, undocumented workers may hold down wage rates. They might also be hired into jobs that might otherwise be available to American workers. All these factors could be argued to have a negative effect on the U.S. job market. At the same time, the impact of immigrants on employment and wages is moderated by other factors. Unskilled, undocumented workers often do jobs that most Americans are unwilling to do. In general, the U.S. workers who face significant job competition from undocumented immigrants are those with few job skills and little education. Other sectors of the labor market are barely affected. Furthermore, although undocumented workers may be hired into jobs that could go to U.S. workers, undocumented works also spend money and create demand that leads to new jobs. In fact, many economists contend that undocumented workers bring net economic benefits to the economy by providing low-wage labor that lowers the cost of goods and services and stimulates economic growth.

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Creating a Business Plan Economic Question: What should you consider when starting a business?

Inquiry Introduction In this unit, you learned about economic institutions and organizations. You also learned about key components of the economic sector, including money, banking, saving, and investing. You also learned about how human capital and entrepreneurship play an important role in economic development. Now, you will apply what you have learned to this Economic Inquiry.

Storyline Suppose you have the opportunity to present a product or a business idea to an investment firm looking to support community businesses. This investment firm has created a program that will bring investors and entrepreneurs together. Before you can pitch your business plan to investors, you will need to come up with an idea. Once you have a solid idea, you will need to build a business plan and develop a pitch to apply for funding for your business.

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Entrepreneurs often need capital in order to make their ideas become reality. In some cases, an entrepreneur may approach investors to get the capital they need to begin production on their good or service.

Background Entrepreneurship plays an important role in the continued development and sustained growth of the U.S. economy. When people have an idea for a good or service, they often want to create and market their product for public use. In order to make their idea a reality, they usually need capital. Although this may seem like a simple task, capital can be hard for the average citizen to acquire. In cases where an entrepreneur may be short on funding, they can approach an investor with the ability to financially support the entrepreneur’s idea in exchange for a piece of the company’s profits. In recent years, entrepreneurship has been increasingly popularized by media and the internet. Television shows like Shark Tank or The Profit dramatize the way in which a person with an idea seeks an investor for their product. On Shark Tank, entrepreneurs present their business plans to a panel of potential investors in an attempt to convince them to invest money into their products. To be successful in their pitches, entrepreneurs have to devise a compelling business plan and narrative.

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In this activity, you will assume the role of an entrepreneur looking to convince investors to give you capital. You will build a business plan based off an idea for a good or service.

Inquiry Process As you consider the Economic Question, you will now get the opportunity to develop a business plan. Following this inquiry will help you to come up with a thorough business plan. You can follow these steps and record your findings in your Interactive Student Notebook: Create a list of ideas you may have for a good or service in your community. Use the handout to help you develop a preliminary idea. Get into groups of four and present your product to your new business partners. Debate which good or service presented by the four of you will be the strongest idea to pitch to an investor. Compose a list of questions about your product’s industry. Will your good or service improve the lives of people in your community? Will it entertain them? Will it help the environment? Use and record reliable sources to answer the questions you develop and conduct market research. 2020 Teachers' Curriculum Institute

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Reflect on the research that you have gathered to develop your business plan. Your plan should include all of the components listed on the handout. Be sure to use evidence and reasoning when appropriate. Present your project to the class. Your business plan should include a 2-3 minute pitch to investors that highlights your product and explains how it works. You should include visual elements to help promote your product. After listening to the pitches made by other entrepreneurs, think about what makes a good business plan. Revise your business plan based on the feedback you have received to ensure that it meets the criteria for a good business plan. By following these steps, you will have created an effective business plan for a good or service that benefits your community. When you are ready, get into your groups and begin investigating the Economic Question.

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Government and the Economy How should the U.S. government carry out its economic roles?

Vocabulary Glossary Vocabulary Cards regulation eminent domain regulatory agency merger deregulation common resource government failure poverty rate

Introduction

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Government is involved in many aspects of our everyday lives, from the water we drink to the taxes we pay.

When you woke up this morning, did you think to yourself, “What is the government going to do for me today?” Probably not. But even if you don't think about it, the government still impacts your daily life. The time log that follows will give you an idea of just how involved the government is in our everyday lives. 6:30 A.M. The alarm on your phone sounds—too early, as always. As you slowly wake up, you scan your notifications to catch up on the latest news. The headline article announces, “The government has just approved new regulations to protect against identity theft from online shopping.” 6:45 A.M. As you get dressed, you stream music from the radio app on your phone in order keep you awake. The music comes through loud and clear, thanks largely to a government agency that assigns a separate frequency to each radio station. Otherwise, a competing broadcaster using the exact same spot on the radio dial might drown Level: A

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out your station. 6:50 A.M. Still bleary eyed, you stumble into the kitchen to make breakfast. You put water on to boil while you scramble a couple of eggs. The government is right beside you as you cook. The water that flows from the tap has been analyzed by your local water department to be sure that it is safe to drink. Government inspectors made sure the eggs were produced and packaged in a way designed to minimize the presence of harmful bacteria. 7:00 A.M. Your grandmother joins you at the kitchen table with the morning paper. She shows you an article announcing an increase in Social Security benefits due to rising living costs. Her pension from the federal government will go up starting next month. 7:06 A.M. As you wait for the school bus, you notice that some potholes in the road have been filled. A paving company hired by the state government has been busy making street repairs. 7:10 A.M. Your bus finally arrives. It is very quiet, and it does not smell of diesel fumes. Your local school district has invested in several battery-powered school buses, and you are lucky enough to ride in one. 7:30 A.M. You reach your destination, a public high school funded by your national, state, and local governments. Governments support public education in part because an educated workforce is key to a productive economy. Your morning has barely begun, and yet government at every level has already provided you with a multitude of services. In this lesson, you will learn more about the widely accepted roles that the government plays in our marketbased economy. You will also explore how the government’s intervention affects your life and the lives of all Americans.

1. How Does the Government Protect Property Rights? Government clearly plays a big role in our economic lives, but is this role too big? Many Americans would say it is. But Jeff Madrick from the Century Foundation, Jon Bakija of Williams College, Lane Kenworthy of the University of California, San Diego, and Peter Lindert of the University of California, Davis disagree. 2020 Teachers' Curriculum Institute

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The evidence shows that more government can lead to greater security, enhanced opportunity, and a fairer sharing of national wealth, and this is the case throughout history of modern capitalism. —How Big Should Our Government Be?, 2016 Without a doubt, capitalism is alive and well in the United States. But is that because of government involvement or in spite of it?

One of the roles of government in the economy is to “coin money and regulate this value.” It does this by printing new currency and maintaining the amount of it in circulation.

The Constitutional Basis for Government Involvement in the Economy The power of the federal government to intervene in the economy comes straight from Article I of the U.S. Constitution. to to to to to to to to

lay and collect taxes. provide for the general welfare. borrow money. regulate interstate and foreign commerce. establish uniform bankruptcy laws. coin money and regulate its value. fix the standard of weights and measures. protect the writings and discoveries of authors and inventors.

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regulation is ultimately based on the powers granted in the Constitution. Government’s Role in Protecting Property Rights The Constitution lays the foundation for a legal system that protects property rights. We often think of property as land, personal possessions, and other physical assets. However, property can also refer to inventions and various forms of expression, also known as intellectual property. No matter what form property takes, property rights entitle the owner to determine how it is used. Economists argue that protecting property rights is essential for our free enterprise system to flourish. Why? Because incentives matter. Ownership of property creates a number of incentives that promote economic progress, including the three listed below.

Private ownership encourages people to take care of their property. If private owners fail to maintain their own property, they are the people who suffer. For example, if you own a house, you have a strong incentive to fix the roof if it leaks. Otherwise, the value of your house will decrease. Private ownership encourages people to make the most productive use of their property. It is in the best interest of owners to use their property in the most productive ways possible based on their needs. The owner of a farm, for example, has every incentive to plant crops that make the best use of local soil and climate conditions. Private ownership encourages people to develop their property in ways that benefit others. Under the law, owners can do whatever they want with their property, but they have the potential to gain by making what they own useful to others. Consider the owners of a health club. Personally, they may have no interest in anything but weight training. Nonetheless, they might decide to offer childcare, nutrition counseling, and spa services to attract more members. By enhancing their health club in ways that benefit others, the owners stand to benefit by increasing the property’s value. Property rights are so basic to our free enterprise system that the government is empowered by the Constitution to protect them. One institution that protects property rights is the court system, sometimes assisted by police forces. Another is the U.S. Patent and Trademark Office (USPTO). This federal government agency protects intellectual property, or property in the form of ideas that have commercial value. It does so by issuing patents and trademarks. 2020 Teachers' Curriculum Institute

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One Exception to Property Rights: Eminent Domain Our nation’s founders took property rights seriously. During the Constitutional Convention in 1787, Gouverneur Morris of New York echoed the sentiments of most delegates when he described property as “the main object of Society.” Still, the delegates recognized that at times, the government must take private property for a public use, such as the building of a road or courthouse. The government does this through the power of eminent domain.

Eminent domain is the power to force the transfer of property from a private owner to the government for a public purpose. This example of one exception to property rights existed long before the United States was founded. But the Fifth Amendment to the Constitution added a new element—paying the private owner for property taken under eminent domain.

No person shall be . . . deprived of life, liberty, or property, without due process of law; nor shall private property be taken for public use, without just compensation.

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Eminent domain is the government’s right to take private property for public use. In 2005, the Supreme Court ruled that private developers could obtain land through eminent domain as long as their redevelopment projects had public benefits. But do such projects qualify as a public use? Not according to this cartoonist.

In 2005, the meaning of public use was called into question by a controversial Supreme Court decision. The case before the Court was Kelo v. City of New London, which pitted residents of a run-down section of New London, Connecticut, against the city government. The city wanted to use its power of eminent domain to take the residents’ property, including land, homes, and businesses, for economic redevelopment. New London’s taking of private property for redevelopment was not unprecedented. In earlier decisions, the Supreme Court had decided that the redevelopment of depressed areas had public benefits that justified a government’s use of eminent domain. However, New London did not plan to use the land it had acquired for public projects, such as schools or a civic center. Instead, it intended to turn the land over to private developers who planned to build a hotel, offices, and condominiums on the site for profit. The city argued that the economic growth that this private development would bring to New London was a public benefit. Some residents who faced the loss of their property disagreed. They argued 2020 Teachers' Curriculum Institute

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that the government’s taking of their homes and businesses for the benefit of a private developer was not a public use. In its decision on Kelo, the Supreme Court sided with the city. A 5-to-4 majority held that the benefits of economic redevelopment do qualify as public use within the meaning of the Fifth Amendment. Justice Sandra Day O’Connor was one of the four justices who did not agree with the majority. In her dissenting opinion, she wrote that the effect of this decision was “to wash out any distinction between private and public use of property—and thereby effectively to delete the words ‘for public use’ from the Takings Clause of the Fifth Amendment.” The Supreme Court’s decision in Kelo provoked a nationwide storm of protest. In response, many states passed laws designed to protect property rights by limiting the use of eminent domain for economic development.

2. What Regulatory Roles Does Government Play in Our Economy? Securing property rights is an important role for government in our economy, but it is not the only role. The federal government is involved in many aspects of the economy by setting and enforcing standards for dozens of industries. Through this regulation, the government seeks to protect the interests of all participants in the economy. One way that the government does this is by ensuring that markets are competitive. Government’s Role in Maintaining Competition Like property rights, competition is essential if markets are going to work the way they are supposed to work. The pressures of competition force producers to use resources efficiently, to develop new or better products, and to keep products and services affordable. Because competition is vital to the economy, the government acts to maintain competition when markets fail to do so. The government’s main guardian of competition is the Justice Department. This cabinet-level department, through its Antitrust Division, enforces the antitrust laws that Congress has enacted over the years. It often works closely with the Federal Trade Commission (FTC). The FTC is a regulatory agency—a unit of government that makes and enforces standards for an industry or area of economic activity. Level: A

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As modern-day trustbusters, the Justice Department and the FTC prohibit practices that restrict competition. When they uncover such practices, they take the offending companies to court. Successful prosecution can lead to fines and jail sentences for the guilty parties.

Price fixing. The illegal practice of price fixing occurs when competitors agree on a price for a good or service. Price fixing can take many forms, from adopting a formula for computing prices to setting a minimum fee for services. Bid rigging. Purchasers—including federal, state, and local governments—often acquire goods and services by seeking bids from competing firms. Bid rigging occurs when competitors agree in advance who will submit the winning bid. That bid, which is the lowest bid, will still be higher than it would have been in a competitive market. Firms that engage in bid rigging may take turns being the low bidder on a series of contracts. Market division. The tactic known as market division occurs when competitors agree to divide a market among themselves. In one type of scheme, each competitor sells to only certain customers. In another, each competitor sells in only certain geographic areas. The Justice Department and the FTC also monitor mergers, in which two separately owned firms combine into one firm. A merger is illegal if it will substantially lessen competition or potentially create a monopoly. The government does allow some natural monopolies to exist. A natural monopoly arises when a single firm can produce or supply a product more efficiently than multiple competing firms can. The American Telephone and Telegraph Company, better known as AT&T, was once a natural monopoly. In the mid-1900s, it controlled the vast majority of the nation’s telephone services.

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In 2018, the telecommunications company AT&T merged with the cable television company Time Warner Inc. Many were concerned that this merger would give the company too much power over consumers.

In the 1970s, however, the Justice Department took action to break up AT&T’s monopoly. After a lengthy lawsuit, the company agreed to spin off seven separate regional phone companies, which became known as Baby Bells. Meanwhile, AT&T continued to provide long-distance telephone services. Figure 11.2A shows how the Baby Bells later merged into three much larger telecommunication companies. Government’s Role in Protecting Consumers, Savers, and Investors

Caveat emptor. This long-standing rule of the marketplace is Latin for “Let the buyer beware.” It serves as a warning to buyers that they purchase goods and services at their own risk. But in today’s complex market, buyers may not have all of the information they need to make sound judgments about products. Instead, they have come to rely on regulatory agencies to provide such information. Consumers, savers, and investors also look to such agencies to ensure that products are safe and dependable. Protecting consumers. Regulation to protect consumers began in the early 1900s. One of the first targets of government regulators was the meatpacking industry. Upton Sinclair, in his novel The Jungle, described what went on in meatpacking plants. There would be meat that had tumbled out on the floor, in Level: A

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the dirt and sawdust, where the workers had tramped and spit . . . meat stored in great piles in rooms; and the water from leaky roofs would drip over it, and thousands of rats would race about on it . . . These rats were nuisances, and the packers would put poisoned bread out for them; they would die, and then rats, bread, and meat would go into the hoppers together. —Upton Sinclair, The Jungle, 1906

Figure 11.2A Analyzing the Historic Breakup of AT&T AT&T held a natural monopoly on a telephone service until it was broken up into AT&T and seven regional “Baby Bells” in 1984. Over time, the remnants of that breakup pieced themselves back together. By 2006, two companies – Verizon and the “new A&T”—dominated the telecommunications industry.

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In 1965, Ralph Nader’s book Unsafe at Any Speed spurred Congress to enact safety standards for cars and other vehicles and to establish the National Highway Traffic Safety Administration. Along with seatbelts, air bags later became a standard safety feature in cars.

Thanks in part to Sinclair’s stomach-turning prose, Congress passed both the Meat Inspection Act and the Pure Food and Drug Act in 1906. This legislation paved the way for a new regulatory agency, now known as the Food and Drug Administration (FDA). The FDA oversees food safety, as well as the testing and approval of drugs before they go on the market. Another wave of consumer regulation began in 1965, triggered by Ralph Nader’s book Unsafe at Any Speed. Nader claimed that automobiles were unsafe and that the auto industry resisted making cars safer because of the added cost. The next year, Congress passed legislation requiring automakers to install seat belts in all cars. This law led to the creation of an agency to set safety standards for automobiles, the National Highway Traffic Safety Administration. In 1972, Congress created the Consumer Product Safety Commission to protect Americans against undue risks associated with consumer products they choose to purchase. This agency now sets standards for more than 15,000 products, from toys to lawn mowers. During President Obama’s first term, a new agency was created to protect consumers in markets for financial products. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 established Level: A

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the Consumer Financial Protection Bureau. This agency’s basic function is to establish and enforce rules that allow consumers to make wellinformed decisions regarding financial products, including mortgages or credit cards.

Protecting savers and investors. Of the many banking-related agencies, the Federal Deposit Insurance Corporation (FDIC), may have the most direct role in protecting savers. The FDIC insures nearly all bank deposits for up to $100,000 per depositor. The Securities and Exchange Commission (SEC) protects investors by making sure they have the information they need to judge whether to buy, sell, or hold a particular security. The SEC establishes and enforces rules to ensure that companies provide that information in a timely and accurate manner. Such regulatory agencies allow Americans to feel confident when transacting business with total strangers. As the former president of the Federal Reserve Bank of Cleveland once observed,

It seems remarkable, when you think about it, that we often take substantial amounts of money to our bank and hand it over to people we have never met before. . . . We trust that . . . the person at the bank who takes our money doesn’t just pocket it. Or that when we use our credit cards to buy a new CD or tennis racquet over the Internet, from a business that is located in some other state or country, we are confident we will get our merchandise, and they are confident they will get paid. —Jerry Jordan, 2000 Government’s Role in Protecting Workers The federal government safeguards the interests of workers through the Department of Labor (DOL). One of DOL’s primary aims is to protect workers’ economic rights. It does this by making sure workers get the wages due to them, fostering workplaces that are free of discrimination, and providing unemployment insurance. Another goal of DOL is protecting workers’ physical well-being. To ensure safe and secure workplaces, DOL relies mainly on the Occupational Safety and Health Administration (OSHA). OSHA sets safety and health standards for industries. When you see construction workers wearing hard hats or highway workers wearing reflective vests, OSHA standards are most likely involved. Since OSHA was established 2020 Teachers' Curriculum Institute

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in 1971, workplace fatalities have decreased by more than 64 percent and injury rates by 73 percent.

The Occupational Safety and Health Administration (OSHA) monitors workplaces to protect workers from accidents and injuries. According to OSHA, since its founding in 1971, the administration has helped to cut fatal accidents in the workplace by more than 64 percent. OSHA has also been instrumental in reducing workplace illnesses and accidents by 73 percent.

The Perils of Government Regulation Regulatory agencies are similar to referees. Their role is to make sure that firms play by the Level: A

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rules and that individuals are protected. But referees sometimes make mistakes, and so do government regulators. Economists cite several problems associated with government regulation, including the three described here.

Overregulation. Regulation can be very expensive, both for the regulatory agencies and for the businesses that must comply with the rulings of those agencies. Sometimes regulations are so detailed and complex that they actually discourage economic activity. The general slope of grain in flat steps of minimum dimension shall not be steeper than 1 in 12, except that for ladders under 10 feet in length the slope shall not be steeper than 1 in 10 . . . Local deviations of grain associated with otherwise permissible irregularities are permitted. A building contractor faced with page after page of such regulations might well decide to simply abandon jobs that require ladders.

Balancing costs and benefits. Most people would agree that regulation has benefited society. Everyone wants clean water, for example, and standards enforced by the Environmental Protection Agency (EPA) have done a great deal to address water pollution. But how clean does water have to be? And at what cost? Consider a lake that was once so polluted that fish could not survive in it. Through regulation, water quality improves and the fish come back. After more regulation and expense, the water becomes swimmable. The water is eventually deemed to be nearly drinkable. But some impurities remain. To remove them would cost as much as has already gone into removing all the other pollutants. Is drinkable lake water a reasonable goal for regulators? Or are the costs of such a level of purity too great to justify?

Regulatory capture. Employees of a regulatory agency need to be familiar with the industry that they are regulating. Where better to find qualified employees for an agency than in the industry itself? And when those agency employees leave government service, who will hire them? The same industry that they formerly regulated, of course. This “revolving door” between government and industry can lead to what economists call regulatory capture. This occurs when regulatory agencies are dominated, or captured, by the industries they regulate. Captured agencies act in the best interests of the industry, rather than in the best interests of the public. 2020 Teachers' Curriculum Institute

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One way to address the problems created by regulation is through deregulation. Deregulation is the process of removing government restrictions on firms’ economic activity. Since the 1970s, Congress has deregulated a wide range of industries, including the banking, airline, cable television, electric power, and interstate trucking industries, among others. The effects of deregulation have been mixed. In the airline industry, for example, the Civil Aeronautics Board controlled both airline routes and ticket prices until deregulation began in 1978. The result of deregulation, as Figure 11.2B shows, was a dramatic rise in the number of Americans flying as airfares dropped and new routes opened up. At the same time, however, deregulation led to greater crowding at some airports. And as air travel became more competitive, weaker airlines had to shut down or merge with stronger airlines to survive.

Figure 11.2B Graphing Gains from Airline Deregulation Before 1978, the Civil Aeronautics Board controlled both domestic airline routes and fares. After the deregulation that year, any domestic airline judged “fit, willing, and able,” was allowed to fly any U.S. route at any price. • Note the drop in average fares, as calculated in 2005 dollars. • With lower fares, the number of Americans flying increased between 1975 and 2010.

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3. How Should Government Address Externalities and Public Goods? Government’s involvement in the economy takes many forms, from filling potholes and regulating alcohol to enforcing business contracts and inspecting oceangoing vessels. But a large portion of what government does, it does in relation to the economy. The government intervenes in two significant ways that affect the economy: by protecting individuals in the economy and making markets—and thus the economy—work better. This second area is why the government intervenes in order to correct two forms of market failure: externalities and public goods. The Government’s Role in Dealing with Externalities Externalities are spillover effects resulting from production or consumption. They are costs or benefits that affect someone other than the producer or consumer of a good or service. Externalities can be negative or positive. Air pollution and secondhand smoke, for example, are negative externalities associated with driving and smoking. Without government intervention, such negative externalities can cause great, even if unintended, harm. Governments can be equally helpful in promoting activities that have positive externalities. Immunizations, for example, prevent individuals from getting harmful diseases. They also prevent individuals from spreading those diseases to others—a positive externality. To encourage immunization, state governments require children to receive vaccinations against common diseases before enrolling in public school. Supporting Positive Externalities: Subsidies and Public Provision Goods and services that generate positive externalities tend to be under produced relative to their benefits. Higher education is a prime example. People who graduate from college gain the benefit of greater earnings. However, education also benefits society by creating a more productive workforce. To support this positive externality, federal and state governments allocate resources to education. They do this through subsidies and public provision, which means providing the education itself. 2020 Teachers' Curriculum Institute

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Figure 11.3A Analyzing Public Opinion on Education Funding student loans and preschools are ways for governments to promote the positive externalities created by an educated citizenry. The survey results here show public opinion on some of these issues. • The left-side graph shows support for a subsidy, providing lowinterest loans. The right-side graph shows support for a public provision, providing preschools. Why do you think many Americans approve of the government supporting positive externalities?

Subsidies. The government subsidizes both the consumers and the producers of education. It gives subsidies to college students in the form of grants, which do not have to be repaid, and low-interest loans. It also gives grants to schools, colleges, and universities. Vouchers are another form of subsidy. A voucher is a coupon to be used to purchase a specific good or service. Some state and local governments provide school vouchers to low-income families to help them send their children to private schools.

Public provision. If a positive externality is large enough, the government may choose to finance the production of a good or service itself. In the field of higher education, federal and state governments provide most of the revenue needed to support public colleges and Level: A

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universities. Other examples of public provision are the U.S. Postal Service and federal air-traffic control systems.

The litter you see lining many highways is a negative externality. The companies that produce the plastic bags, soda cans, and other items that litter roads do not bear the cost of cleaning them up. Nor do the consumers who buy and use these items before throwing them away. In many places, cleanup is done by volunteers who adopt a section of highway and work to keep it litter free.

Limiting Negative Externalities: Command-and-Control versus Market-Based Policies One of the most widespread and troubling side effects of both production and consumption is environmental pollution. Governments can seek to limit this externality in two ways— through command-and-control policies and through market-based policies.

Command-and-control policies. The term command and control comes from the military, and refers to the use of authority by a commanding officer to accomplish a mission. The commander exercises authority by issuing orders that others are expected to obey. As one writer puts it, “the idea is that people do what you tell them to do, and if they don’t, you yell at them until they do, and if they still don’t, you throw them in the brig for a while.” Regulatory agencies that adopt 2020 Teachers' Curriculum Institute

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command-and-control policies follow a similar approach, issuing rules that others are expected to follow. The Environmental Protection Agency (EPA) has used command-andcontrol policies to reduce air pollution. The EPA sets standards for air quality and requires states and cities to meet them. There are problems with this approach, however. As economist Robert W. Crandall observed,

The Congress or the EPA may decide to control the wrong substances or to control some discharges too strictly. Congress’s own Office of Technology Assessment concluded, for example, that attempting to reach the EPA’s goal for urban smog reduction could cost more than $13 billion per year, but result in less than $3.5 billion in improved health, agricultural, and amenity benefits. —Robert W. Crandall, “Pollution Controls,” The Concise Encyclopedia of Economics, 2008

Market-based policies. Economists generally prefer the use of market-based policies to deal with negative externalities. Such policies use incentives, rather than rules and enforcement, to change producers’ behaviors. One market-based policy is a corrective tax, which the government levies on producers of pollution. Corrective taxes give producers an incentive to reduce their harmful waste products because the tax acts as a penalty. These taxes also have the benefit of raising revenue. Corrective taxes have been used by local governments in an attempt to reduce the amount of trash that households produce. Under these “pay as you throw” tax schemes, households are charged for each bag of garbage that they put out for collection. In response to the trash tax, most households try to find ways to reduce their output of garbage. The effect has been to reduce the amount of waste that ends up in local landfills. Another market-based policy is known as cap and trade. When using this approach, the government sets a limit, or cap, on the total amount of a pollutant that businesses can emit each year. The government then issues a limited number of pollution permits to every firm that emits that type of pollution. The permit gives the holder the right to pollute a certain amount. As illustrated in Figure 11.3B, this scheme allows firms to sell their Level: A

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pollution permits to one another. Firms that can easily cut their emissions below their caps have an incentive to do so because they can sell their leftover permits. Firms that are unable to cut emissions enough to reach their caps may buy those extra permits to avoid pollution penalties. At the same time, the added cost of buying permits gives heavy polluters an incentive to decrease their emissions as much as possible. The EPA used a cap-and-trade policy in the 1990s to reduce the output of sulfur dioxide—a major cause of acid rain—emitted from coal-burning power plants. Coal-fired power plants throughout the United States were directed to reduce their sulfur emissions by 50 percent over a fixed period. They were allowed to meet this target in any way they chose, including by purchasing permits from plants that came in under target early. The approach resulted in sulfur dioxide emissions being reduced more rapidly than anticipated.

Figure 11.3B Comparing Command-and-Control Regulation with the Cap-an-Trade Approach This diagram illustrates the cost of reducing emissions from an old and a newer factory, using two regulatory approaches. • Using command-and-control policy, each factory is required to make the same reductions, no matter what the cost might be. • Using a cap-and-trade approach, the two factories are issued pollution permits. The factories have the flexibility to buy and sell permits, thus achieving the same total reduction at a lower cost. 2020 Teachers' Curriculum Institute

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Negative Externalities and the Tragedy of the Commons Negative externalities often arise when property rights are not well defined. The air, for example, is what economists call a common resource. Everyone has access to a common resource and for this reason, it can easily be overused and even destroyed. Economists call this problem the tragedy of the commons . Ecologist Garrett Hardin coined this term.

The tragedy of the commons develops in this way. Picture a pasture open to all. It is to be expected that each herdsman will try to keep as many cattle as possible on the commons . . . [One herdsman] asks, “What is the utility to me of adding one more animal to my herd?” . . . The rational herdsman concludes that the only sensible course for him to pursue is to add another animal to his herd. And another . . . But this is the conclusion reached by each and every rational herdsman sharing a commons. Therein is the tragedy. Each man is locked into a system that compels him to increase his herd without limit—in a world that is limited. Ruin is the destination toward which all men rush, each pursuing his own best interest. —Garrett Hardin, “The Tragedy of the Commons,” Science, 1968

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Economists apply the tragedy of the commons to a variety of common resources, including Earth’s atmosphere and oceans. Pollution and other negative externalities, they argue, result from poorly defined property rights. Without such rights, people lack the incentive to care for common resources and to ensure that those resources are preserved for future use. Preserving Common Resources: Tolls, Quotas, and Privatization A number of government policies are aimed at preserving common resources. One policy is to require everyone who uses a common resource to pay a toll, or fee. Highway tolls, for example, provide revenue that can be used to maintain roads, as well as function as a corrective tax. To avoid paying tolls, some drivers will seek other routes, join carpools, or take public transportation. By providing an incentive to limit use of certain roads, tolls help reduce congestion. A second way to preserve a common resource is to establish a quota, or maximum amount of a resource that a person can use or consume in a given period of time. The ocean, for example, is a common resource, as are the fish that live in it. Like the herders in Hardin’s example, people who fish for a living have little incentive to limit their catch. If they do, someone else will come along and take the fish they left behind. The predictable result has been overfishing, which threatens to destroy several fisheries in U.S. coastal waters. By setting and enforcing fishcatch quotas, however, the government can control the percentage of the fish stock harvested each year. These quotas will help preserve this common resource. A third way to deal with a tragedy of the commons is to turn the common resource into a private resource—that is, to privatize it. Private ownership restores the incentive to preserve the resource. Consider the problem of overfishing. The government might assign a group of fisheries the property rights to one stock of fish in an area. Their “ownership” of these fish gives them an incentive to preserve the resource by limiting the amount they catch each year.

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Turning common property into private property is one way to deal with a tragedy of the commons. This cartoonist takes privatization to a new level, suggesting how units of government might be converted into private enterprises.

Government’s Role in Providing Public Goods The government plays another widely accepted economic role as a provider of public goods.

The legitimate object of government, is to do for a community of people, whatever they need to have done, but can not do, at all, or can not, so well do, for themselves —in their separate, and individual capacities. —Abraham Lincoln, 1854 Consider a good that could be produced by a private firm, such as a dam to control the flooding of a river. Some people in the river’s floodplain might be willing to pay for the protection the dam provides, but the firm would not be able to provide that protection only to those people and withhold it from others. Anyone living in the floodplain would be able to enjoy that protection free of charge. No profit-seeking firm can be expected to provide a good that consumers do not have to pay for. A government, by contrast, does not seek to make a profit. Rather, it can pay for public goods with tax dollars, thus ensuring that all taxpayers contribute to the cost. Analyzing the Costs and Benefits of Providing Public Goods Level: A

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Most people want government to provide public goods, such as national defense and streetlights. But as the scarcity-forces-tradeoffs principle reminds us, no government has the resources to provide everything that people might want. It has to make choices, but how? One way is to analyze the costs and benefits of producing that good. Consider a proposal before a city council to widen a road in order to relieve congestion. City planners provide the council with detailed estimates of the costs of buying the needed land and hiring a construction company. Estimating the benefits is more challenging. If the road is widened, commuters are likely to spend less time and use less gas stalled in heavy traffic. How much less is uncertain. Nonetheless, estimates of these benefits are made and assigned a dollar value. At this point, political considerations may also play a part in the council’s decisions. If enough voters want a wider road, the council members might decide to approve the project even if the costs seem likely to out-weigh the benefits. The result would be an inefficient use of the city’s scarce resources. The funds used to widen the road might well have provided more benefits to more people had they been used differently. Economists describe situations in which government intervention leads to an inefficient use of resources as government failures. Such failures arise for several reasons. Politicians who want to stay in office may support legislation that pleases voters but is not cost effective. Or they may engage in logrolling—agreeing to vote for another lawmaker’s legislation if that lawmaker agrees to vote for their own legislation. Such compromises often lead to wasteful spending and economic inefficiency. Politicians may also be influenced by interest groups when making decisions. Interest groups are organizations dedicated to getting certain policies enacted into law. Although such policies have high utility for a specific group, they may not benefit the economy as a whole. People who work for regulatory agencies may also contribute to government failure. Staying employed is an incentive for them to find new problems to solve. Government employees may press for more regulation even if it is not the most efficient solution to a problem.

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Figure 11.3C Analyzing Costs and Benefits of a Public Provision This graph summarizes the cost-benefit analysis of a proposal to build a high-speed train system in California. The main costs were construction, operation, and maintenance of the train systems. • Passenger revenue: People riding the train will have to purchase tickets. • Benefits to high-speed train passengers: Passengers riding the trains will save time and money. • Benefits to highway travelers: The high-speed rail will save time and money for highway travelers by reducing congestion, pollution, and accidents. • Benefits to air travelers: The high-speed rail will help reduce air travel delays by providing an alternative form of transportation.

4. What Does Government Do to Promote Economic WellBeing? Before the onset of the Great Depression in the 1930s, the federal government generally followed a hands-off policy toward the economy. Except for times of national emergency, such as the Civil War and World War I, the role of the government in the lives of ordinary people Level: A

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remained small. Then came the stock market crash of 1929, which plunged the nation into the worst economic crisis in its history. How the Great Depression and World War II Changed U.S. Economic Policy The 1929 stock market crash triggered a financial crisis that forced thousands of banks to go out of business. Millions of depositors lost their savings. Consumers slowed their spending, and firms cut back production or shut down altogether. The economy took a nosedive, causing the Great Depression to begin. At first the government did little, assuming that the economy would stabilize on its own. But as the economy worsened, many people looked to the government for help. In 1932, Franklin D. Roosevelt won the presidency by promising a different approach—a New Deal for the American people. The New Deal greatly expanded the federal government’s role in the economy. It created dozens of new programs and agencies aimed at reforming the banking system, helping businesses, and providing jobs. Most New Deal agencies did not outlast the Great Depression. However, the huge federal bureaucracy spawned by the New Deal lived on. The Depression ended when World War II began. But the federal government did not return to its traditional hands-off role. Instead, it took charge of the wartime economy, overseeing industries as they converted from consumer to military production. To pay for the war effort, the government also sharply increased individual and corporate income taxes. When the war ended, the federal government ended its supervision of industrial production. But many Americans feared a return to hard times and widespread unemployment. Congress responded to those fears by passing the Employment Act of 1946.

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During the Great Depression, the government’s role in the economy expanded. One of the government’s goals was to put people back to work. The workers shown here were hired through a government program known as the Works Progress Administration (WPA).The WPA put some 8.5 million Americans back to work constructing roads, bridges, public buildings, parks, and airports.

This act clearly stated an important role for government in stabilizing the U.S. economy:

The Congress hereby declares that it is the continuing policy and responsibility of the Federal Government to . . . promote maximum employment, production, and purchasing power. —Employment Act of 1946 This act gave the federal government an active role in managing the nation’s economy. To carry out that role, the act established the Council of Economic Advisers. This council helps the president formulate sound economic policies. The act also established a Joint Economic Committee that includes members from both houses of Congress. The committee’s job is to review the state of the economy and advise Congress on economic policies. Level: A

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The government promotes economic stability, in part, by trying to moderate booms and busts. In 2008, with the economy sagging, the government sought to spark business activity with a stimulus package. It sent taxpayers stimulus checks, with the hope that people would spend the money on consumer goods and services.

Government’s Role in Promoting Economic Stability Americans clearly benefit from economic stability. In a stable economy, jobs are secure, goods and services are readily available, and prices are predictable. Producers, consumers, and investors can plan for the future without having to worry about sudden upheavals in the nation’s economy. The government promotes economic stability in part by creating a widely accepted currency—the dollar—that maintains its value. The government also promotes stability by stimulating business activity during economic slowdowns. It does this through tax incentives, which 2020 Teachers' Curriculum Institute

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encourage businesses to invest in new capital equipment, and through tax rebates, which encourage consumers to spend more money. In 2008, for example, difficulties in the housing market sent the economy into a tailspin. Reacting to this uncertainty, consumers cut back on spending. In order to generate more spending, Congress enacted an economic stimulus package—legislation specifically designed to stimulate business activity. The package called on the Internal Revenue Service to mail checks of $600 or more, depending on family size, to 130 million households across the United States. The nation’s leaders encouraged Americans to spend their stimulus checks on consumer goods and services. Income Distribution and Poverty in the United States Markets allocate resources efficiently, as Adam Smith noted when he described the invisible hand of the marketplace. But Smith did not conclude that markets allocate resources fairly. Some people, for example, end up with vastly higher incomes than others. Every year, the U.S. Census Bureau charts the distribution of income in the United States. It starts by ranking households on the basis of their incomes. Then, it divides the entire list of households into five equal parts, called quintiles. The bottom quintile contains the lowest incomes, and the top quintile contains the highest incomes. The Census Bureau also calculates the percent of total income each quintile received. In 2016, for example, the bottom fifth received 3.1 percent of all income, while the top fifth received 51.5 percent. Clearly, income is not distributed equally in the United States. Another tool for measuring the distribution of income is the poverty rate. This rate is the percentage of households whose incomes fall below a certain dollar amount determined by the Census Bureau. That dollar amount, called the poverty threshold, is the estimated minimum income needed to support a family of four, including two children. The poverty threshold can vary depending on family size and composition. For example, a family with two adults and one child is expected to live on less income than a family with one adult and four children. The government considers families to be poor if their incomes fall below its poverty threshold. In 2016, by this measure, more than one family in twelve lived in poverty. Altogether, the members of those families Level: A

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represented 12.7 percent of the U.S. population. The poverty rate, then, was 12.7 percent in 2016. Poverty rates vary depending on factors such as age, race, ethnicity, and family composition. It is also worth noting that the Census Bureau’s brackets for each quintile vary from year to year due to changes in the economy. Therefore, an individual may be in the bottom fifth one year, only to move to another bracket the following year even if their income were to remain stagnant. This illustrates a hallmark of American society know as economic mobility, or the ability of people to move up and down the economic ladder.

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One way that the government redistributes income is by issuing food stamps, or EBTs, to people with low incomes. Known as SNAP, this program provides vouchers, accessed through an electronic debit card, that can be used to buy food. In addition to promoting well-being, subsidizing food for poor people benefits society as a whole by creating a healthier population. This is an examples of a positive externality.

Government’s Role in Redistributing Income For much of our nation’s history, the poor relied mainly on friends, family, and private charities to provide for their basic needs. Local communities sometimes established poor houses and poor farms to house the very poor. Otherwise, the poor were left to fend for themselves as best they could. Then came the Great Depression. With it came an expanded role for government in the economy. New Deal programs aided millions of Americans. The Social Security Act, for example, did much to reduce poverty among disabled and older Americans. However, these programs did not lift every family out of poverty. During the 1960s, the federal government launched a War on Poverty to help the nation’s neediest families. Congress devised dozens of antipoverty programs that together created an economic safety net. Those programs had some success. The poverty rate for families dropped from 18.1 percent in 1960 to 10.1 percent in 1970. Level: A

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Since the 1960s, most antipoverty programs have involved some form of income redistribution, a policy designed to reduce the gap between the rich and the poor. This policy works by taxing wealthier members of a society and then distributing that money to the poor to achieve greater income equality. Redistribution takes a number of forms, including those described here.

Welfare. When most people talk about welfare, they are referring to Temporary Assistance for Needy Families (TANF). The TANF program, funded largely by the federal government but run by the states, provides benefits, services, and work opportunities to needy families. In some states, TANF benefits come in the form of cash transfers, or direct payments of cash from the government to individuals. Other TANF benefits are distributed in the form of goods or vouchers, rather than cash. These in-kind transfers include food stamps, public housing, school lunches, and Medicaid. For example, when a person receives health services through the Medicaid program, the government pays the health care provider. No cash goes to the Medicaid recipient.

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Figure 11.4 Analyzing the Growth of Income-Redistribution Programs The federal government’s role in redistributing income has grown dramatically over the past 70 years. This graph shows changes in spending on four programs since 1960. • Social Security: Supports people with disabilities and retirees • Unemployment assistance: Assists people who are unemployed through no fault of their own • Assistance to students: Provides grants to schools and scholarships and loans to students who continue their education past high school • Food stamp program: Helps low-income families buy food

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These people are learning job skills by participating in a welfare-to-work program offered by Goodwill Industries International in Pittsburgh, Pennsylvania. Goodwill has been providing vocational training to people living below the poverty threshold since it was founded in Boston in 1902. The goal of this training is to give people the skills they need to move out of welfare and into the workforce.

Earned income tax credit. The government also helps the working poor through the Earned Income Tax Credit . Low-wage workers can claim this credit when they file their federal income tax forms. The credit is applied against whatever taxes they would normally pay. Depending on a worker’s family size and income, the credit can exceed those taxes. If it does, the worker receives a tax refund. Unemployment insurance. Employers, through federal and state taxes, contribute to a fund that provides unemployment insurance for workers. If workers are laid off from their jobs, the state sends them payments—unemployment compensation—for a certain period of time or until they find another job. Each state administers its own unemployment insurance program, based on federal standards. The Unintended Consequences of Antipoverty Policies Through its antipoverty policies, the government redistributes income in a way that is intended to help those living below the poverty threshold. Yet, critics charge that these policies have had unintended negative 2020 Teachers' Curriculum Institute

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consequences for the very people they are meant to help. These critics worry that antipoverty programs promote dependence on the government and reduce people’s incentive to become selfsufficient.TANF, food stamps, Medicaid, and the Earned Income Tax Credit are what economists call means-tested programs—that is, they are tied to family income. The more a family earns, the fewer benefits that family can claim. For this reason, recipients of government assistance may have little incentive to get a job and to earn money. If their incomes exceed the poverty threshold, they will lose their government benefits. For welfare recipients with minimal skills and education, getting a job may indeed make them worse off. This is because the types of jobs available to low skill workers usually pay minimum wage and have little or no benefits. Consider a single mother with less than a high school education. She leaves welfare and takes a low paying job with no health insurance benefits. She still must struggle to support her children on her low wages. But now, because she is working, she and her children are ineligible for government-provided health services. She may also receive less money than she did while on welfare.

Unemployed workers who find a job get the benefits and satisfaction of earning a paycheck. But going back to work may also involve financial tradeoffs. Some workers find they have new costs that erode the value of their earnings.

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Policymakers have developed a variety of proposals to address such problems. One is to provide job training and education for welfare recipients to expand their knowledge and skills and increase their opportunities in the job market. Another is to raise the cap on certain means-tested programs so that benefits are gradually reduced as income rises. Both of these proposals would lead to higher costs and, most likely, higher taxes in order to pay for those increasing costs. A third possible solution is public service employment. As it did during the Great Depression, the government could pay the unemployed to perform useful work. However, this might cause a flood of workers to shift from private jobs to more secure government jobs—at a great expense to taxpayers. As always, when resources are limited, whatever choices a government makes will result in tradeoffs. You may not be aware of these tradeoffs now, but at some point you will be. Why? Because government programs are funded by tax dollars, and once you enter the working world, you will become a taxpayer. In later lessons, you will learn more about taxes and how they are used to support the many roles that the government plays in our lives.

Lesson Summary The government plays a limited but important role in the economy. The government protects property rights, regulates the marketplace, corrects market failures, and promotes the economic well-being of the American people. How does the government protect property rights? The government is empowered by the Constitution to protect private property rights. It does this through the court system, police forces, and the Patent and Trademark Office. The government may limit property rights through its power of eminent domain. What regulatory roles does government play in our economy? The government uses its regulatory power to maintain competition; safeguard consumers, savers, and investors; and protect workers. The government carries out these tasks through regulatory agencies, like the Federal Trade Commission and the Food and Drug Administration, which create and enforce standards and regulations for industries. How should government address externalities and public goods? The federal and state governments implement a variety of 2020 Teachers' Curriculum Institute

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policies to limit negative externalities and support positive externalities. They also provide public goods that are deemed necessary or desirable. What does government do to promote economic well-being? During the Great Depression, the role of the government in the economy greatly expanded. Since then, the government has acquired even more responsibility for the economic well-being of its citizens. When necessary to preserve economic stability, the government stimulates the economy by spending more money. The government also redistributes income to combat poverty.

Health Care Reform in the United States The United States continues to debate how to make health care more affordable and available to individuals. The cost of health care is high, and a large percentage of people lack health insurance. This essay looks at the U.S. government’s most recent approach to health care reform.

Problems with the Health Care System The United States spends more on health care than any other country in the world. In 2016, health care costs amounted to 17.9 percent of gross domestic product, or around $10,348 per capita. Yet, according to the World Health Organization, the United States ranks just 37th out of almost 200 countries for the quality of its care. The U.S. health care system relies on a mixture of public and private insurance. Unlike other developed countries, however, most health insurance in this country is private and provided mainly through employers. This employer-based system means that most Americans depend on their jobs for their health coverage. If they lose their jobs, they lose their coverage. Americans who are not offered insurance through their jobs, or who have no job, may have no health insurance at all. In 2017, roughly 12.2 percent of Americans were uninsured. Nearly everyone agrees that health care reform is necessary, but they disagree about the type of reform. Some people call for universal coverage—insurance for everyone—paid for mainly through government funding. Others call for an improved private insurance Level: A

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system. Still others suggest a combination of the two approaches. Recently the U.S. government has approached health care reform through the Affordable Care Act, and discussions continue today as to how to better address the health care system in the United States.

The Single-Payer Option This option calls for government-sponsored, universal health care. It is called single-payer because all the funding comes from one source: either the government or an institution established by government. A single-payer system would be supported by taxes and be free to all citizens, much like the national health care systems in Great Britain and Canada. Both public and private medical providers, such as doctors and hospitals, could exist under this system. But there would probably be an increase in public health facilities. The government would also play a strong role in regulating health care and controlling costs. Supporters and opponents of this option disagree about its likely impact. Supporters note that everyone would have health insurance under a single-payer system. No one would have to decline treatment or go into debt because of the cost of medical care. Supporters also assert that government controls would hold down health care costs, and that a single-payer system would reduce paperwork and thus be more efficient. Opponents contend that this approach would result in an expensive, government-run program that would increase taxes. They argue that it would actually be less efficient because it would not be based on free market competition and that the quality of health care would decline for many Americans. They also fear that such a system would give patients less freedom to choose the doctor and type of care they want.

The Private Option This option would keep much of the current system intact but place a greater emphasis on private insurance and individual choice. It would continue the multi-payer approach, with money for health care coming from households, insurance companies, and government. But it would reduce government health care spending and reduce employer-based coverage. In their place, it would offer tax credits to households to help them buy their own insurance. This approach would seek to expand coverage, while keeping the health care system in private hands. Supporters say the private option would encourage free market competition among health care insurers and providers. They argue that 2020 Teachers' Curriculum Institute

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this is the best way to lower costs and improve the quality of health care. They point out that this option would relieve companies of the burden of providing health care and give Americans more freedom of choice. People could choose their insurance and not lose it if they changed jobs. Opponents argue that under this proposal millions of people would remain uninsured. Tax credits alone, they say, would not be enough to help poorer Americans buy insurance. They also doubt that market competition would effectively hold down medical costs. They contend that the health care system would still be overly complicated and expensive.

The Hybrid Option This option combines elements of the current system with increased government assistance and guarantees. It doesn't overhaul the health care system the way the single-payer approach would, nor does it abandon private or employer-sponsored plans. Depending on how it is structured, the hybrid option can provide either expanded or universal coverage. A typical program allows people who are already insured to keep their existing health plan. But it also provides publicly funded plans for those who are not insured. An example of a hybrid option is the Affordable Care Act (ACA) that was enacted in March of 2010 under President Obama. The ACA is a hybrid healthcare option as it provides more affordable healthcare coverage to the public if needed through the government. However, already insured individuals can keep their existing insurance policy. Nicknamed “Obamacare”, the ACA had three main goals to better the health care system in the United States. The first goal involves making health insurance more affordable, and therefore more available, to a greater number of people. In order to do so, the law provides consumers with subsidies. These subsidies lower the costs of health care for households whose income fall below a certain bracket. The second primary goal of the ACA is to expand the current Medicaid program to cover all adults who have an income a certain percentage below the federal poverty level. The hope is that by expanding the parameters in order to qualify for Medicaid, more people will have access to affordable healthcare. Finally, the third goal of the ACA is to pursue other methods in order to lower the overall cost of health care in the United States. After the implementation of the ACA in 2010, the uninsured rate within the United States slowly declined, hitting a low of 10.9 percent uninsured by the end of 2016. However, since then there have been Level: A

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debates about repealing the ACA and its overall effectiveness. In 2017, President Trump and congressional Republicans attempted to repeal section of the ACA. Although these attempts were unsuccessful, there was a slight increase in uninsured Americans in 2017, rising to 12.2 percent.

Continuing Debates There continues to be debate about the best way to address health care in the United States. At the moment, Republicans continue to fight for more privatized health care, whereas Democrats are looking for a government-run health care system. Due to the charged nature of politics, it is hard to predict what new health care reforms will be proposed and how the health care system within the United States will continues to change.

Regulating Science and Technology Advances in science and technology often have positive effects. The computer revolution, for example, has had many beneficial effects by promoting economic growth and helping to expand our knowledge of the world. At the same time, scientific and technological advances also have the potential to do harm. For that reason, government must sometimes regulate developments in science and technology to protect individuals and society. In addition, it must also provide protection for businesses that develop new ideas and technologies. This essay explains how scientific discoveries and technological innovations create the need for rules and regulations to protect individuals and businesses.

Protecting Society It would be nice if all developments in science and technology were wholly beneficial. Unfortunately, that's not the case. Even innovations whose impact is largely positive may have negative side effects. Some argue that it is the responsibility of government to ensure that these side effects, or negative externalities, do as little harm as possible. Industrial chemicals are one example. The companies that develop new chemicals do so to meet a need. They may invent more effective pesticides to protect crops from insects or create new plastics or 2020 Teachers' Curriculum Institute

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solvents for a wide range of applications. When these chemicals are released into the environment, however, they can cause serious harm to humans and the natural world. For that reason, federal and state governments, through such agencies as the U.S. Environmental Protection Agency, place regulations on chemical producers in an effort to prevent serious damage. The need for government regulation can also be seen in other fields. In medicine, for example, pharmaceutical companies develop new drugs to treat a variety of ailments. Although some of these drugs may represent a major medical advance, others may have harmful effects. This was certainly true a century or more ago, when medicines were sold with little guarantee of their safety. Today, however, drugs must undergo rigorous testing to ensure they are safe and effective. This is one of the important functions of the U.S. Food and Drug Administration. Other areas of innovation may present similar risks. Today, scientists are doing DNA research to unlock the secrets of the genetic code. This research could lead to breakthrough cures for major diseases or could result in genetically modified (GM) foods that help solve problems of world hunger and malnutrition. But genetic research could also have severe and negative consequences. DNA testing could endanger individual rights by identifying and classifying people with genetic diseases, thus violating their right to privacy. GM foods could potentially pose health risks to humans or cause harm to naturally occurring species of plants and animals. Government must set rules and regulations in these and other fields of scientific research to protect individuals and society from potential harm.

Protecting Businesses Government also sets rules to protect the rights of individuals and businesses that make significant advances in science and technology. Such advances are a form of intellectual property, or ideas that have commercial value. Because government is responsible for protecting property rights, it must also protect intellectual property. It does so through the patent system. Individuals or businesses that develop new products or technologies can apply for patent protection. If granted, a patent will protect a piece of intellectual property for a specific period of time, usually 20 years. During that time, only the person or company that owns that idea can benefit from it commercially. This protects a company's investment and prevents other businesses from copying the idea and profiting from it. Level: A

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The federal government may even apply rules to support individuals or businesses engaged in scientific or technological development. If the government has good reason to believe that a project involving scientific research will produce positive side effects, or positive externalities, it may provide grant money or other assistance to support that project. This is another form of protection for businesses involved in scientific and technological innovation.

Protecting Individuals from Technology Addiction Technology has also been proven to have yet another negative side effect: addiction. Recent studies have shown that technology has addicting qualities that can lead to overuse by consumers. A study published in June 2018 by the University of Texas examined the consequences of technology on people’s ability to perform tasks. The study found that those who had their smartphones nearby, even though they were on silent, performed far worse on a series of cognitive tests than those whose phones were in another room. This study reveals the addicting nature of technology in our lives. What has become an essential component of our existence can also be a distraction from the real world. There have also been some shocking statistics associated with social media and the internet . For example, in 2017, YouTube reported that people watched 1 billion hours of media content per day. More than 800 million people use the social media app, Instagram, for at least 30 minutes per day. With easy access to technology, people are consumed by it and often spend large portions of time on social media or internet platforms. Some feel as if it is the responsibility of the government to help combat technology addiction, and cite examples of countries such as South Korea, which has created government-sponsored treatment centers for young adults who are addicted to technology. However, others feel as if government involvement would infringe on their right to privacy and limit personal use of internet and social media.

The Impact of Product Standards on Trade and Economic Activity Product standards are designed to ensure the quality and safety of goods. They also have economic effects. This essay examines product 2020 Teachers' Curriculum Institute

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standards and their impact on the domestic economy and world trade.

Product Standards: What and Why Product standards set guidelines for food and drug products and manufactured goods to ensure that those products are safe and reliable. Both government agencies and private industry set product standards, though for slightly different reasons. The government sets standards to protect public health and safety. Industries impose standards because of government regulations, but also to promote efficiency and ensure customer satisfaction. The federal government began to impose product standards in the early 1900s. At the time, many food and drug products sold to American consumers were unsafe. Some were processed in unsanitary conditions, and others contained hidden or even toxic ingredients. In 1906, Congress passed the Pure Food and Drug Act to set safety standards for food and medicine. Later it passed laws regulating other consumer goods. Today, the government inspects food and drugs and sets standards for thousands of consumer products. Various federal agencies carry out this task, including the Food and Drug Administration, the Department of Transportation, and the Consumer Product Safety Commission. Private industries must conform to government standards. But they also set their own standards for reasons of efficiency and market competition. By setting product standards, a company tries to ensure that its products are uniform and can compete with similar products produced by other companies. This is true whether the product is construction materials, canned foods, or jet engines.

Overregulation However, sometimes standards can become extreme, resulting in overregulation. Overregulation occurs when a government or governing body maintains a large amount of control over companies, product production, or distribution. This can affect a country’s ability to participate in trade. India, for example, is a country that experiences overregulation in regard to global trade and the economy. India currently has strict laws when it comes to being open to foreign investors and enterprises. The country has these laws in place with the goal of protecting local businesses within India and building a nation on the foundations of self-sufficiency. However, because of these laws, India is not a major participant in the global economy through trade as Level: A

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foreign companies struggle in operating within the country. In recent years India’s regulations regarding global industry have eased slightly. Government control has lessened, and more foreign industries have been allowed to operate within the country, and entrepreneurship is being encouraged. As a result, India’s growth rate has increased by as much as 7 percent. There is also discussion as to overregulation within the United States as well in regard to businesses. Often cited are the overregulation of small or local business by the federal government. These regulations tend to place large financial burdens on startups and small businesses; the financial data released in 2017 revealed that small businesses pay at least $12,00 per year in regulatory costs. These regulatory costs are imposed through the Internal Revenue Code, as well as the Affordable Care Act and its labor rules. In fact, many small businesses cite insurance as a major financial burden on business growth as the Affordable Care Act only applies to certain businesses. For instance, the Affordable Care Act only applies to businesses with 50 or more employees. Therefore, most smaller companies are not assisted by the Affordable Care Act and are responsible for bearing the financial responsibility of providing insurance to their employees. Many are concerned that these regulations restrain job growth and deter entrepreneurship, as well as negatively affect small business. However, some argue that these regulations are necessary in order to maintain stability in the U.S. economy.

Effects on the Domestic Economy When product standards are first imposed, they may have negative economic effects. They may raise the costs of production by requiring higher quality materials or additional steps in the manufacturing process. These costs are typically passed on to consumers in the form of higher prices. In the long run, however, product standards generally have positive economic effects. They make product quality more consistent, since all companies producing a given product must conform to the same standards. This helps to “level the playing field” and make markets more competitive. Standards also result in more reliable products and better product information for consumers. This leads to lower transaction costs, the amount of time and money consumers spend shopping for products. Producers benefit, too, because they know the standards they must meet to sell their goods. They are less likely to produce substandard goods that might affect their sales or prompt a product recall. All these effects of product standards tend to promote 2020 Teachers' Curriculum Institute

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economic efficiency.

Impact on World Trade By improving efficiency and competition, product standards are generally good for international trade, too. Sometimes, however, they can act as a trade barrier. A notable example occurred in 2003 with the discovery of BSE, or “mad cow” disease, in one cow. This resulted in a shutdown of U.S. beef exports to foreign countries. Health concerns have also caused the European Union to block imports of genetically modified crops, including U.S. soybeans. Australia has banned U.S. grape imports to protect its domestic crop from a California grape virus. In each of these examples, the goal of the product standard was to protect health and safety, not to restrict trade. Although product standards may sometimes limit trade, the cost is generally worth the benefit when consumer safety is at stake. To cite another well-known example, in 2007 U.S. food inspectors discovered the toxic chemical melamine in pet food imports from China. Later, melamine showed up in other Chinese goods, including dairy products. U.S. officials blocked imports of these goods to protect American consumers. At the time, many Americans called for even tougher restrictions on foreign food products to avoid potential health hazards. In the end, product safety is an essential component of a healthy economy.

Economic Inquiry: Government in the Economy You have just read about the ways in which our government involves itself in the economy. Complete the open-ended inquiry below to further explore the economic roles of the government, and how such roles are carried out.

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Taxes and Taxation Who and what should be taxed?

Vocabulary Glossary Vocabulary Cards tax equity tax incidence deadweight loss tax rate proportional tax progressive tax regressive tax

Introduction

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Every year, millions of Americans fill out forms like these to pay taxes to the government.

On February 14, 1929, seven men—all but one of whom were members of an organized crime gang—were brutally gunned down by members of a rival gang dressed as police officers. These murders, which made headlines across the country, became known as the Saint Valentine’s Day Massacre. The man believed to have been behind the massacre was Al Capone, one of the most notorious gangsters in American history. Capone, who went by the sinister nickname “Scarface,” was a Chicago mob boss during the Prohibition era of the 1920s. At the time, the sale of alcohol was banned by the Eighteenth Amendment. Capone made a fortune from the illegal liquor trade, gambling, and other criminal activities. By ruthlessly eliminating his rivals, Capone rose to the top of Chicago’s criminal world. Capone quickly became a public figure around the nation. When he was questioned about his activities, he would often respond: “I am just a businessman, giving the people what they want”; and, “All I do is satisfy a public demand.” Level: A

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Federal law enforcement agents, led by Eliot Ness, attempted to arrest Capone on murder and racketeering charges for years. But Capone always had an alibi. In addition, no one was willing to testify against him. Then, in 1930, a key piece of evidence found during a routine warehouse raid allowed federal prosecutors to finally bring Capone to justice. Al Capone—the man branded “Public Enemy Number One”— was finally charged with the crime of . . . tax evasion. For several years in the late 1920s, Capone had failed to pay his income tax. Yet, he lived like a king, spending extravagantly on cars, clothes, and other luxuries. The Justice Department knew that such lavish spending was a sign of substantial income, but they could not prove that Capone was making any money until they found a coded set of accounts that belonged to him. When they filed charges, Capone is said to have responded, “The income tax law is a lot of bunk. The government can’t collect legal taxes from illegal money.” But Capone was wrong. In 1931, he was convicted of tax evasion and sentenced to 11 years in prison. He was also forced to pay $80,000 in fines and court costs. This ended Capone’s career as a mobster. In this lesson, you will learn about the United States’ historical relationship with taxes and how they are used today to finance government operations. You will read about the various types of taxes and how they are collected and spent by governments at the local, state, and national levels.

1. What Are Taxes and How Should They Be Levied? Most people know what a tax is—a mandatory payment to the government. But ask them if they look forward to paying taxes and you will most likely get “no” for an answer. Generally, no one enjoys giving their hard-earned money to the government. However, regardless of how much people dislike them, taxes are unlikely to ever go away. Benjamin Franklin famously stated, “In this world, nothing is certain but death and taxes.” By comparing taxes to the one truly inevitable event in life—death—Franklin was saying that taxes are an unavoidable consequence of living in society. They serve the important function of funding communities, states, and the country 2020 Teachers' Curriculum Institute

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as a whole. Taxes: The Price of Civilization Although taxes may be burdensome, they make government possible. Without taxes, there could be no public institutions—no legislature, courts, or system of law enforcement— and therefore no ordered society. “Taxation,” said Supreme Court justice Oliver Wendell Holmes Jr., “is the price we pay for civilization." Taxes have existed for as long as societies have been organized under common rule. In early civilizations, such as those of Egypt, Mesopotamia, and China, taxation took many forms. Farmers and craft workers gave up shares of the goods they produced to the government, and traders were taxed on their commerce. In addition, people had to provide labor for building temples, city walls, and other public works. Taxes were paid in the form of goods and labor for centuries, but eventually these were replaced by taxes in the form of money.

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In ancient Mesopotamia, tax records were recorded in Cuneiform writing on clay tablets similar to this one. One of the common taxes on Mesopotamian citizens was a labor tax, which could range from farming and other manual labor to military service.

Today, taxes are collected and used for various purposes. They supply revenues to support the functions of government, such as national defense and criminal justice; to pay for infrastructure, such as roads and bridges; and to fund welfare and public services, such as education and health care. Taxes also promote social and economic goals. For example, a tax may be placed on certain goods and services to limit their use. A tax on cigarettes or alcohol, for instance, can discourage their consumption. Taxes can also be used to redistribute income. For instance, higher taxes might be placed on one group, such as the wealthy, to provide benefits or services to another group, such as the poor.

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Despite their many useful functions, taxes have never been popular with the citizens who pay them. Thomas Paine referred to taxes collected by Europe’s monarchs as “plunder,” or stolen goods. Throughout history, resentment over taxes has given rise to tax protests, riots, and rebellions, including the rebellion that launched our country’s fight for independence.

Because American colonists had no vote in the British Parliament, they complained about “taxation without representation.” As this cartoon implies, however, taxes were still unpopular among individuals after the colonies gained independence.

How Our Nation’s Founders Viewed Taxation Taxation was the main issue that sparked the American Revolution. At the time, Britain taxed the American colonies but refused to give them representation in Parliament. The colonists believed they should have a say in how they were taxed. The popular slogan “No taxation without representation” became a rallying cry for colonial discontent. As protests mounted, Level: A

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some members of Parliament called on the British government to change its tax policy. “Your scheme yields no revenue,” declared the statesman Edmund Burke. “It yields nothing but discontent, disorder, disobedience. After gaining their independence from Britain, the American people retained a cautious attitude toward taxation. Although they accepted the need for taxes, they also wanted to limit the government’s tax powers. Some of these limits are written into the U.S. Constitution. Article I, Section 8, Clause 1, which provides the basis for federal tax law, says that Congress shall have the power “to lay and collect Taxes, Duties, Imposts and Excises.” But the clause goes on to limit this power in two key ways. Taxes can be levied, or collected, only for the country’s “common Defence and general Welfare,” not for the benefit of individual citizens. Federal taxes must be the same in every state. The framers of the Constitution also inserted a clause that limited the power of Congress to tax individual income. This clause was overridden in 1913, however, by the passage of the Sixteenth Amendment, which allowed for the establishment of the federal income tax. Adam Smith’s Four Tax Maxims Shortly before Americans declared independence in 1776, Adam Smith published The Wealth of Nations. In this famous book on economics, Smith laid down four maxims, or guiding principles, of taxation that have influenced thinking surrounding taxes ever since.

Equity. The first of Smith’s maxims is equity, or fairness. In his view, wealthy citizens benefit most from government and, as such, can most afford to pay its costs. He wrote, “It is not very unreasonable that the rich should contribute to the public expense, not only in proportion to their revenue, but something more than in that proportion.” In other words, Smith believed that the rich should pay a higher percentage of their income in taxes than should the poor should pay. Certainty. Smith’s second maxim is that the taxes a citizen owes should be “certain, and not arbitrary.” He wrote, “The time of payment, the manner of payment, the quantity to be paid, ought all to be clear and plain to the contributor.” Otherwise, government officials may be tempted to abuse the tax system for their own benefit. 2020 Teachers' Curriculum Institute

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Convenience. The third maxim is convenience. Smith wrote, “Every tax ought to be levied at the time, or in the manner, in which it is most likely to be convenient for the contributor to pay it.” In other words, the tax system should not be overly complicated. Taxpayers should find the process of paying their taxes simple, straightforward, and predictable. Efficiency. Smith’s fourth maxim—efficiency—is designed to keep the economic costs of the tax system to a minimum. Smith believed that taxes should produce maximum gain for the government, while causing minimum loss for taxpayers. “Every tax,” he wrote, “ought to . . . take out and to keep out of the pockets of the people as little as possible over and above what it brings into the public treasury of the state. The Tax Equity Debate: Who Should Pay and Why? Most economists would agree with the theory of Smith’s four maxims. Nevertheless, they often disagree about how to put those maxims into practice. One of the most hotly debated issues is the principle of tax equity, the idea that the tax system should be fair. Although economists support the principle of equity, they differ over how best to achieve it. The crucial issue in the tax equity debate is who should pay. Economists offer two basic approaches to this problem: the ability-topay principle and the benefits-received principle. The ability-to-pay principle mirrors Smith’s first maxim. It says that citizens should be taxed according to their income or wealth. Therefore, people with higher incomes should pay more tax than individuals with lower incomes. Federal and state income taxes are based on this principle. For example, a lawyer who earns $200,000 a year pays a higher percentage of income in taxes than does a teacher who earns $50,000 a year. The benefits-received principle says that those who benefit from a particular government program should pay for it. For example, people who drive should pay for the upkeep of the highway system. Gasoline taxes that fund road repairs are based on this principle, as are highway and bridge tolls.

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Many states and cities levy occupancy taxes on the use of hotel and motel rooms. Such taxes are typically charged to the customer. But if a hotel lowers its room rates to keep the cost to customers down, the incidence of the tax falls at least in part on the hotel owner.

Who Ends Up Paying Taxes and Why? 2020 Teachers' Curriculum Institute

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tax is one of the difficulties of devising a fair tax system. Initially, it may seem obvious that the producer or consumer who is legally required to pay the tax does so; however, that is not always what happens. The economic burden of a tax—what economists call tax incidence—may not necessarily fall on the person who is responsible for paying the tax bill. To see why, consider the tax on hotel rooms. Many state and local governments levy “occupancy” taxes on the use of hotel and motel rooms. Hotel and motel owners are required to pay this tax revenue to the government. Most hotels simply add the tax, which is a percentage of the room rate, onto a customer’s bill. When this happens, the customer bears the burden of the “occupancy” tax. But this extra cost might cause some hotels to lose customers because it raises the price of hotel rooms. If a hotel owner responds by lowering room rates to reduce the overall cost to the customer, then the hotel owner, not the customer, is bearing some of the burden of the tax. As this example illustrates, tax incidence is affected by elasticity of supply and demand. Elasticity, you may recall, is a measure of sensitivity to a change in price. In a market with very elastic demand, consumers are highly sensitive to price changes. A tax that raises prices may drive some consumers out of the market. If demand is inelastic, however, adding a tax to the price of a good or service will have much less effect on consumers’ willingness to buy. Similarly, in a market with very elastic supply, producers are highly sensitive to price changes to do business. A tax that raises the cost of doing business may drive some producers out of the market. If supply is inelastic, however, adding taxes to other costs will not have much effect on producers’ willingness to sell a good or service. In general, the burden of a tax will fall on the side of the market that is less elastic. If consumers are more likely to leave the market if prices rise, then producers will bear more of the tax burden in order to keep customers. But if producers are more likely to abandon the market, the incidence of taxation will fall more heavily on consumers. Any government hoping to create an equitable tax system must take tax incidence into account. Yet, many people are unaware that tax burdens can, and often do, shift. As economist N. Gregory Mankiw points out,

Many discussions of tax equity ignore the indirect effects of taxes and are based on what economists mockingly call the Level: A

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flypaper theory of tax incidence. According to this theory, the burden of a tax, like a fly on flypaper, sticks wherever it first lands. This assumption, however, is rarely valid. – Principles of Economics, Volume 1, 2007 Taxes and Efficiency: Deadweight Losses and the Costs of Compliance There is less debate among economists about Smith’s fourth maxim—efficiency. There are many ways to raise revenue through taxation. One tax system is considered more efficient than another if it raises the same amount of revenue at less cost to taxpayers. Obviously, a tax is, itself, a cost that taxpayers must bear. But taxes also impose two other kinds of costs: deadweight losses and the cost of tax compliance. A deadweight loss occurs when the cost to consumers and producers from a tax—due to lost productivity or sales—is larger than the size of the tax revenue it generates. As economics writer Charles Wheelan put it, a deadweight loss “makes you worse off without making anyone else better off. Taxes can create deadweight losses by reducing people’s incentives to be as productive as they would otherwise choose to be. For example, consider the effect of state and federal income taxes on a job seeker who is offered a position that involves long hours of overtime. If she could keep every dollar she would earn by working the extra hours, the job might look more attractive. But knowing that she will have to pay at least one-third of her earnings in taxes, she decides that it is not worth working extra hours. She turns down the job and continues looking for work. Not only is she still unemployed, but the economy has lost what she might have produced had she taken the job. That lost productivity is a deadweight loss. Another source of tax inefficiency is the cost of complying with the tax code. Every year, U.S. taxpayers spend many hours, and often hundreds of dollars, preparing their income tax forms. Moreover, as Figure 12.1 shows, the overall cost of compliance has been rising yearly. The time and money spent on tax preparation are resources that, if we had a more efficient tax system, could be used productively in other ways.

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Figure 12.1 Measuring the Cost of Tax Compliance According to the Tax Foundation, a nonprofit organization dedicated to educating U.S. taxpayers, the cost of tax compliance is rising year by year. • The foundation estimated that in recent years, individual taxpayers spent roughly 3.2 billion hours or more filling out over 165 million federal income tax forms. • Within that time frame, the cost of federal tax compliance by all taxpayers – individual, firms, and nonprofits – was more than $4.4 billion.

2. What Kinds of Taxes Will You Pay in Your Lifetime? On tax day each year, usually April 15th, harried taxpayers hurry to finalize their tax forms before the midnight deadline. The clock ticks. The race is on to get federal income tax forms submitted before the Level: A

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filing deadline. Taxation Basics: Tax Base and Tax Rates In 2018, the April 17 tax day deadline almost coincided with another tax-related day, known to some as “tax freedom day.” This is the date every year when it is estimated that average Americans will have earned enough to pay all their taxes for that year. In 2018, that date was April 19—109 days into the year. This means that Americans spent nearly one-third of 2018 working to pay their federal, state, and local taxes. Many types of taxes make up the average American’s tax burden. All these taxes consist of two basic elements: the tax base and the tax rate. The tax base is the thing that is taxed, such as personal income, a good sold at a store, or a piece of property. Taxes are defined according to their tax base. For example, income tax is based on personal income. A property tax is based on the value of property, such as a home. The tax rate is the percentage of income—or of the value of a good, service, or asset—that is paid in tax. For example, if the income tax rate were set at 20 percent, taxpayers would have to pay an amount equal to 20 percent of their taxable income. Tax Structures: Proportional, Progressive, and Regressive Taxes are also defined by their structure, which in turn depends on tax rates. Economists identify three types of tax structures: proportional, progressive, and regressive. Each structure has its advocates and critics.

Proportional taxes. A proportional tax is a tax that takes the same share of income at all income levels. For example, a proportional income tax of 10 percent would tax all incomes, regardless of amount, at that rate. Critics of proportional taxes argue that such taxes fail the test of fairness, because they tax the rich and the poor at the same rate, even though the poor have less ability to pay the tax than do the rich. A 10 percent income tax levied on an individual who makes $25,000 a year, for example, represents a greater sacrifice than the same tax levied on an individual who makes $250,000 a year. Advocates of this tax structure, however, claim that a proportional tax is fair precisely because everyone pays an equal share. They also point out that proportional taxes are efficient because they are simple to calculate and easy to collect. 2020 Teachers' Curriculum Institute

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Figure 12.2A Comparing Taxes with Other Spending Categories This graph shows how many days in a year the average American spends working to pay different federal, state, and local taxes. Note that the number of days worked to pay individual income taxes exceed any other category.

In recent years, Estonia and several other Eastern European countries have adopted a proportional income tax, or flat tax. For example, Slovakia introduced a flat tax in 2004 so that rich and poor alike pay a 19 percent tax on income. Supporters argue that this helps the economy by attracting foreign investors. Its simplicity also leads to less tax evasion. However, critics point out that a flat tax can hurt the middle class. In 2013, Slovakia abolished the flat tax in favor of a progressive tax.

Progressive taxes. A progressive tax is a tax that takes a larger share of income as income increases. A progressive tax is based on the ability-to-pay principle. Most federal taxes, including the federal income tax, are progressive. The main argument in favor of progressive taxation is the equity argument. A progressive tax gets larger as income increases. Thus, it places a greater tax burden on the wealthy—where advocates believe it should be—than on the poor. Critics of progressive taxation, however, believe that placing an unequal burden on the rich is fundamentally unfair. In effect, they argue, such a tax punishes people for accumulating wealth and may Level: A

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create a disincentive to work, save, and invest. They also complain that creating different rates for different income levels leads to a more complex, and therefore less efficient, tax system.

Regressive taxes. The third tax structure, the regressive tax, is a tax that takes a smaller share of income as income increases. Governments do not set out to impose higher tax rates as incomes fall. But a tax that is proportional—that applies a single rate to everyone— can effectively function as a regressive tax if it takes a bigger bite out of the incomes of poor people than those of wealthy people.

Sales taxes, for example, are regressive. To understand why, consider a low-income person who earns $20,000 a year and spends $10,000 of it on taxable goods and services. If the sales tax rate is 5 percent, that person pays $500 in sales tax a year. This amount represents 2.5 percent of the low earner’s income. Compare that with the tax burden of a person who earns $100,000 a year and spends $30,000 on taxable goods and services. At the same tax rate, the high earner pays three times as much sales tax, or $1,500. But that figure represents only 1.5 percent of the high earner’s income. When the percentage of income claimed by a proportional tax goes down as income goes up, the tax is considered regressive. 2020 Teachers' Curriculum Institute

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Critics of taxes that tend to be regressive argue that they turn the ability-to-pay principle on its head. Instead of taxing most heavily those who are most able to pay, such taxes place the greatest burden on those least able to pay. Advocates of proportional taxes, however, argue that they need not be regressive. High earners, they point out, may choose to spend the same percentage of their income on taxable goods and services as people with lower incomes. In such cases, the tax is flat, not regressive, with high earners paying more as they consume more.

Some people argue that making income a progressive tax is unfair to high wage earners, who would have to pay a much higher percentage of their income to taxes than low wage earners. However, making income a proportional tax also has issues, as this comic suggests.

Individual Income Taxes The largest share of tax revenue taken in by the federal government comes from individual income taxes. The majority of states also impose an income tax on their residents. The federal income tax and most state income taxes are progressive taxes. The federal income tax applies to all U.S. citizens and residents with Level: A

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income above a certain minimum level. For example, a single adult who earned less than $10,400 in the year of 2017 was not required to file a federal income tax form that year. The Internal Revenue Service is responsible for issuing federal income tax forms and processing tax returns. The IRS also works to ensure compliance with the tax code, the set of laws that govern federal taxes. Over time, these laws have grown in size and complexity. Since 1954, Congress has enacted dozens of significant changes to the income tax code. The tax code is now thousands of pages long. The IRS collects taxes from workers using a “pay as you earn” system. Under this system, also known as withholding, employers take out a certain amount of tax from each paycheck. At the beginning of each year, most workers receive a W-2 form , which lists their wages for the previous year and the amount of tax that was withheld.

Figure 12.2B The federal income tax is a progressive tax. The table shows how marginal tax rates for a single taxpayer rise as income increases. You can see from the graph that the average tax rate for most taxpayers is less than their marginal tax rate. This is true because not all income is taxed at that marginal rate.

Taxpayers submit tax returns between January 1 and tax day. They are required to declare all of their income for the previous year, including wages, investment earnings, business profits, and other types of income. If the IRS questions the accuracy of a taxpayer’s return, it may order an audit, or formal review of the return. Taxpayers who fail to comply with tax laws may face fines or, like Al Capone, imprisonment.

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Figure 12.2B shows the federal income tax rates for single adults in various income brackets for 2017. As income rises, the marginal tax rate rises as well. The marginal tax rate is the rate at which the last dollar a person earns in a given year is taxed. The table in Figure 12.3B shows seven marginal tax rates for single adults in 2017, ranging from 10 to 39.6 percent. These rising rates make the income tax a progressive tax. Suppose you earned $15,075 in 2017. The first $9,325 of your income would be taxed at the lowest rate of 10 percent. The remaining $5,750 would be taxed at the next highest rate of 15 percent. This rate—15 percent—would be your marginal tax rate, because it is the rate you would pay on the last dollar earned that year. Because your income is taxed at two different rates, your average tax rate will be lower than your marginal tax rate. In this case, your average tax rate in 2017 would be just over 12 percent. The graph in Figure 12.3B shows both marginal and average tax rates at different income levels. Payroll Taxes The second-largest share of federal tax revenue comes from payroll taxes. A payroll tax is a tax on the wages a company pays its employees. Of the several kinds of payroll taxes, the two most important are the Social Security tax and the Medicare tax. Both are used to fund large federal social insurance programs. The Social Security tax is set at a fixed rate, which is paid half by the employer and half by the employee. People who are self-employed pay the entire tax themselves. In 2017, the total Social Security tax rate was 12.4 percent. Because its rate is fixed, the Social Security tax appears, at first glance, to be a proportional tax. However, it is actually regressive, for two reasons. First, the Social Security tax applies only to wages, salaries, and self-employment income. It does not apply to income from investments. Second, only earnings up to a specified maximum amount, or cap, are taxed. In 2017, that cap was $127,200. Earnings over that amount are not taxed. Thus, Social Security claims a smaller share of income as income rises. The Medicare tax is also split evenly between employer and employee. In 2017, the total Medicare tax rate was 2.9 percent, half of which—1.45 percent—was withheld from employees’ earnings. The Medicare tax is not capped. However, as of 2017, a single taxpayer’s income above $200,000 faces a Medicare tax of an additional 0.9 Level: A

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percent. Many states also levy payroll taxes. An unemployment tax is a state payroll tax that is used to assist workers who lose their jobs. Some states also levy a state disability tax , which funds state programs to help workers who are injured on the job. Property Taxes Taxes on property are a major source of revenue for many state and local governments. Property taxes are commonly levied on real property, which consists of land and buildings. Some governments also tax personal property, such as cars and boats.

Many schools are funded by the property taxes of the surrounding area. Money from these taxes is used to buy new textbooks, hire more teachers, and provide better equipment for students to work with. However, areas with lower property taxes might have a harder time funding their schools. This may cause students in wealthier areas to have greater educational advantages.

Property taxes are proportional taxes that charge a fixed percentage of the value of a property. That value is calculated by an assessor, a public official who determines the value of a property for taxation purposes. If the assessed value of a property changes—a common occurrence in the real estate market—property taxes also change to 2020 Teachers' Curriculum Institute

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reflect the new assessed value. In many communities, property taxes are a major source of revenue for public schools. However, the practice of funding public schools with property taxes has many critics. Some charge that it is unfair to require all property owners to pay such taxes when not all of them have or will use the public schools. Others question the equity of basing school funding on property taxes. These critics point to the fact that lowerincome school districts with low property values cannot raise as much revenue as higher-income school districts can. Funding schools in this way can therefore put lower-income students at an educational disadvantage because the school might be unable to buy new books or hire more teachers. Sales Taxes Another important source of state and local revenue is the sales tax. This type of tax levies a percent charge on the purchase of a wide variety of goods and services, from manufactured items to meals served in restaurants. Sales taxes are relatively easy to collect and provide critical funding for state and local governments. But as you read earlier, sales taxes tend to be regressive because people with higher incomes typically spend less on goods and services as a share of their income than do lowerincome individuals. To limit the regressive effects of a sales tax, many cities and states do not tax necessities, such as food and medicine. Corporate Income Taxes Governments at all levels levy various types of business taxes. The largest business tax is the federal corporate income tax, which is applied to the profits of corporations. Like individual income taxes, corporate taxes are progressive, applying a higher tax rate to higher levels of corporate income. It might seem that placing high taxes on corporations and other businesses would help relieve the tax burden on ordinary citizens. In reality, the cost of corporate taxes is passed along to individuals—to customers in the form of higher prices, to employees in the form of lower wages, and to shareholders in the form of smaller dividend checks. As one economist put it, “Purely and simply, business taxes, like all other taxes, . . . are paid for by people.” Excise and Luxury Taxes Federal, state, and local governments also earn revenue from excise and luxury taxes, both of which tax consumption of certain goods and services. Excise taxes are typically levied on goods and services that a Level: A

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government wants to regulate. For example, alcohol and cigarettes are taxed to discourage their use. Because of their association with alcohol and cigarettes, excise taxes are sometimes called sin taxes. Like other sales taxes, excise taxes are generally regressive. Luxury taxes, as the name implies, are levied on the sale of luxury goods, such as fur coats and private jets. Luxury taxes are progressive, because the consumption of luxury goods increases as income increases. The theory behind such taxes is that a person who can afford to buy a fur coat or a private jet can easily afford to pay an extra tax on it. In practice, however, luxury taxes have not always worked the way lawmakers intended. In 1990, for example, Congress passed a luxury tax on expensive furs, jewelry, cars, private airplanes, and yachts. Because of the tax, wealthy people who might have purchased such products decided not to. As demand for the luxury goods dropped, the firms that supplied them laid off workers. Within a year, according to a government study, the tax had destroyed 330 jewelry industry jobs, 1,470 aircraft industry jobs, and 7,600 jobs in the boat-building industry. In 1991, these job losses cost the federal more than $24 million in lost income tax revenue and unemployment benefits paid to laid-off workers. This amount was more than all of the revenue generated by the luxury tax that same year. The 1990 luxury tax illustrates the unintended consequences of poorly thought-out tax legislation. In this case, lawmakers failed to realize that the demand for luxury goods is actually quite elastic. In 1993, Congress repealed the luxury tax on everything except cars costing more than $30,000. The luxury car tax expired in 2003.

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The toll you pay for crossing a bridge is a type of tax. This money may help pay for the maintenance of the bridge, or it may help to pay for other infrastructure costs throughout the community or state.

User Fees and Tolls Have you ever paid a toll on a bridge or an entrance fee to a national park? If so, you have paid a user fee or toll. Other examples of user fees and tolls include paying to park in public lots, to swim in public pools, or to use public highways. User fees and tolls are fixed charges levied on the use of a public service or facility. Fees and tolls are based on the benefits-received principle because those who use a facility pay the tax. User fees and tolls are proportional taxes in that everyone pays the same rate, regardless of income. They become regressive or progressive only when a given fee tends to fall more heavily on lowincome or high-income taxpayers. Estate and Inheritance Taxes The federal government imposes an estate tax on assets left to heirs by someone who dies. The heirs, or inheritors of such assets, pay the tax. Many states also levy an estate tax, sometimes called an inheritance tax, in addition to the federal tax. Estate taxes are progressive, because larger estates are taxed at a higher rate. Some critics argue, however, that estate taxes are unfair because they impose an additional tax on property and wealth that may already have been taxed during a person’s lifetime. Estate taxes may also discourage saving. Critics who oppose the estate tax sometimes call it a “death tax.” “Death and taxes may be inevitable,” Level: A

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one critic has said, “but they shouldn’t be related.”

3. How Do U.S. Governments Spend the Revenue They Raise? In 2017, the federal government collected about $3.4 trillion—that is, $3,400,000,000,000—in tax revenue from its citizens. Such an enormous sum raises an obvious question: what does the federal government do with it all? Federal Revenue Sources Most of the federal government’s tax revenue comes from four sources. Individual income tax is the largest source, followed by payroll taxes and the corporate income tax. The fourth main source is excise taxes. Figure 12.3A shows these sources, along with the share of total revenue provided by each type. Even with these four major taxes, the government typically does not take in enough revenue to cover all of its expenditures. This gives rise 2020 Teachers' Curriculum Institute

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to the federal deficit, or the shortfall between tax revenues and government expenditures in any given year. To make up this difference, the government borrows money. Federal borrowing takes place through the sale of government bonds, which include Treasury bills, savings bonds, and other government-issued certificates of debt. When the government sells a bond to an investor, it is taking on a debt that it promises to repay with interest in the future. However, selling government bonds to make up for a federal deficit increases the national debt. The national debt is the total amount owed by a nation’s government as a result of borrowing. Federal Spending: Mandatory and Discretionary Every year, the federal government creates and proposes a budget to determine how it will spend its revenues. Like all government budgets, it is based on a fiscal year, rather than a calendar year. A fiscal year is a 12-month accounting period. The federal fiscal year begins on October 1 and ends the following year on September 30. The fiscal year is then identified by the year in which it ends. Fiscal year 2017, for example, began on October 1, 2016 and ended on September 30, 2017.

Figure 12.3A Analyzing Sources of Federal Revenue Individual income taxes provide the largest share of federal revenue. Payroll taxes, which fund Social Security and Medicare benefits, also provide a large portion of revenue. Because tax revenues do not always cover spending, the government also borrowed money to cover the deficit. Level: A

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Figure 12.3B Tracking Mandatory and Discretionary Spending Over the years, the percentage of federal revenue dedicated to mandatory spending has grown. Most recently, about two-thirds of federal revenue has been spent on interest and entitlement benefits. The remaining third has been used for discretionary spending. By far the largest discretionary item is defense spending.

In the federal budget, spending is divided into two broad categories: mandatory and discretionary. These broad categories and their subdivisions are represented in the circle graphs in Figure 12.3B. Mandatory spending is spending that is fixed by law. The only way for Congress to change the amount of money allocated to mandatory spending is to enact new legislation. The two main categories of mandatory spending are interest on the national debt and entitlements. Entitlements are programs through which individuals receive benefits based on their age, income, or some other criteria. Entitlement programs include Social Security, Medicare, and welfare. The amount of money spent on entitlement programs depends on the number of people who sign up for them. As the bar graph in Figure 12.3B indicates, the percentage of federal revenue dedicated to mandatory spending has grown significantly over the past several decades. 2020 Teachers' Curriculum Institute

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The other main category of spending, discretionary spending, is made up of expenditures that may be raised or lowered as Congress sees fit. As mandatory spending has grown in recent years, the share of revenue available for discretionary spending has shrunk. By far the largest amount of discretionary spending is spent on national defense. The rest supports government funding for education, scientific research, health care, and foreign aid, among other activities. A portion also funds federal grants to state and local governments. State and Local Government Revenue Sources Like the federal government, state and local governments receive the majority of their money from taxes. However, state and local officials face certain problems in raising revenue that the federal government does not. Some state constitutions, for example, prohibit state lawmakers from enacting certain types of taxes. Seven states, for instance, ban individual income taxes. Other states limit how much certain taxes can increase from year to year. In Massachusetts, for example, property taxes cannot increase by more than 2.5 percent a year. Such restrictions can be changed only if voters approve amending the state constitution. In addition, citizens play a much larger role in tax policy at the local and state levels than at the federal level. Many states and localities require voters to approve tax hikes through tax referendums—direct popular votes on an issue. Some states, such as California, require a two-thirds majority of voters to approve increases in many types of taxes. In part because of these limitations, state and local governments rely on certain revenue sources that are not used at the federal level, such as property and sales taxes. Many states also run lotteries, large-scale legal gambling games organized to raise money for a public cause. As of 2017, 44 states, along with the District of Columbia, U.S. Virgin Islands, and Puerto Rico, held lotteries. The first graph in Figure 12.3C shows the percentages of state and local revenue that come from various sources. Spending by State and Local Governments The second graph in Figure 12.3C shows categories of spending by state and local governments. Unlike the federal government, which spends the bulk of its revenue on entitlements and defense, state and local governments devote large shares of their revenue to services that directly affect young people and their families. The most important of those services is education. As of fall of 2017, Level: A

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more than 50 million children were enrolled in public elementary and secondary schools throughout the United States. The average amount spent on each of these students was $12,300 per year. About 92 percent of that money came from state and local governments. Law enforcement and fire protection are two other responsibilities relegated mainly to local governments. In many communities, police protection is the second largest public expense after education. State and local governments also fund a variety of health and social services, often with assistance from the federal government. Typical examples include public health clinics for low-income families, health care centers for the mentally ill, and childcare for low-income working families.

Figure 12.3C Analyzing State and Local Spending Revenue State and local governments rely on revenue from various sources and spend their money in different ways. As these graphs show, revenues in 2015 came mainly from taxes and federal funding, while around half of all expenditures went to education, health and social services.

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Over the last decade, California has experienced many large wildfires. These fires can lead to billions of dollars worth of damages. Taxes from local and state governments, and even from the federal government, can help pay fire fighters to put out these fires before they cause even greater damage.

Many other services are also funded at the state and local levels. For example, state and local governments spend money to build and maintain roads and bridges. They create and maintain parks and playgrounds for the public to enjoy, as well as fund public libraries, civic auditoriums, and museums. All of these services have been developed in response to public demand. The ever-present challenge is finding the money to pay for what the public wants. Because many state constitutions require balanced budgets, states that run short of funds must either raise taxes or cut programs. Either way, people are likely to object. The fact is that although most people want the services that government provides, few people are happy to pay the taxes needed to fund those services. Former U.S. senator Russell Long once poked fun at this contradiction by reciting this jingle:

Don’t tax you. Don’t tax me. Tax that fella behind the tree. Taxes may not be a big issue in your life yet. But once you begin Level: A

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earning a regular income, they will be. You may be shocked when you get your first paycheck to see how much is deducted in income and payroll taxes. At that point, the question we started with—Who and what should be taxed? —may seem more important. And it should. No matter what form they take, in the end, all taxes are paid by individuals just like you.

Lesson Summary Taxes are necessary to fund government operations and services. The three levels of U.S. government—federal, state, and local—levy various types of taxes to supply the revenues they need. What are taxes and how should they be levied? Taxes are mandatory payments to some form of government. Ideally taxes should be designed with equity and efficiency in mind, though economists differ on how to achieve these goals. The burden, or incidence, of a tax does not always fall on the person taxed. Instead, it may be divided between consumers and producers, based on the forces of supply and demand. What kinds of taxes will you pay in your lifetime? Taxes are structured in three basic ways proportional, progressive, or regressive— depending on their tax rates and effects. Among the main types of taxes are income taxes, payroll taxes, property taxes, sales taxes, and excise taxes. How Do U.S. Governments Spend the Revenue They Raise? The federal government spends most of its money on entitlements, interest payments, and national defense. State and local governments spend their revenues on a variety of services, mainly in the areas of education, public safety, and social welfare.

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Economic Inquiry - Investigating the Impact of Excise Taxes Economic Question: How would a sugary drink tax affect your community?

Inquiry Introduction In this unit, you explored our government’s economic roles and examined the many kinds of taxes at work at local, state, and federal levels. Now, you will apply what you have learned in this Economic Inquiry. You will investigate the Economic Question to take a closer look at one type of tax and consider how it would affect your community.

Storyline Suppose your city council is debating whether to approve a new measure, Measure Z. Measure Z introduces a 2-cent-per-ounce tax on the distribution of sugary drinks. The revenue collected from the tax would be put toward improving the public park system and promoting the use of outdoor spaces to encourage an active lifestyle within the community. You have been selected to be part of a committee to give the city council a recommendation on the sugary drink tax. The committee will conduct research on the Economic Question, examine evidence to take a stance on the measure, and present an argument to the city council.

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Berkeley, California, was the first city to approve a sugary drink tax. To assess the economic impact of a sugary drink tax where you live, you can ask questions and research how the tax impacted Berkeley’s economy. Would the tax impact your community in the same way?

Background Around the United States, cities have adopted a sugary drink tax. This type of tax charges an extra fee for sugary drinks, such as soda, sports drinks, and sweetened juices. This is an example of an excise tax—also known as a “sin tax”—because the tax is levied on goods that are considered unhealthy or harmful to society. In 2015, Berkeley, California, was the first city in the United States to implement a sugary drink tax. Since then, other cities have followed Berkeley’s example. Whenever a sugary drink tax—or other excise taxes like it—are proposed, activists for and against the tax speak up. Advocates of the sugary drink tax believe that it will help increase revenue and discourage people from unhealthy behavior, while opponents argue that the taxes are regressive and negatively impact the poor. Opponents also claim that the revenue gained from the taxes are an unreliable source of income for the city.

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which stance to take. One way is to conduct an inquiry. You will follow the steps below and record your findings in your Interactive Student Notebook: Identify the problem. Ask supporting questions that will help you answer the Economic Question. For example, you may want to know, Who is impacted by the tax? Have businesses been affected in cities that have this type of tax? Research answers to the questions and record your sources. You can investigate the economic and health impact of such taxes and consider if a sugary drink tax would have the same effect in your community. Make sure that the sources you are using are reliable. Use the information you gathered to create a pros and cons list. Analyze the list to consider both sides of a sugary drink tax in your community. What are the costs and benefits of this kind of tax in your community? After acknowledging both sides of the policy solution, take a stance on the Economic Question. Write a clearly stated claim. Build an argument to support your claim. Use evidence from your research and reasoning to support your answer. Take informed action by presenting your argument to the city council. Presenting a well-crafted recommendation can help influence policy in your local community. By following these steps, you will become more informed about economic issues in your community. You will better understand the role of government and taxes in the economy. When you are ready, get into your committees and begin investigating the Economic Question.

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In this activity, you will take on the role of a committee member to investigate how a sugary drink tax could affect your community.

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MEASURING THE ECONOMY

Measuring the Economy How do economists measure a nation’s economic health?

Vocabulary Glossary Vocabulary Cards inflation economic indicators gross domestic product (GDP) unemployment rate inflation rate consumer price index (CPI) business cycle recession

Introduction

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Economists use various kinds of data to assess the health of an economy.

What does it mean to say that an economy is healthy? Can an economy be sick? Though an economist might not use that exact term, the answer is yes. Consider what happened to Germany’s economy after the country’s defeat in World War I. By the time that World War I ended in 1918, the German economy was in poor shape. To make matters worse, Germany was forced to sign a treaty agreeing to pay for the war damage done to the victors, especially Britain, France, and Belgium. When the bill for war reparations arrived in 1921, it was staggering: 132 billion German marks. To pay its debts, the German government began printing more money. As the number of marks in circulation soared, their value plummeted. A loaf of bread, for example, that had cost less than 1 mark at the end of the war cost 10 marks in 1921. This same loaf of bread rose to 250 marks in January 1923, and six months later, its price was 3,465 marks. By November 1923, inflation in Germany had spiraled out of control. A Level: A

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simple loaf of bread now cost 200 billion marks. A wheelbarrow full of money could not buy a newspaper. Restaurants stopped printing menus because prices were rising too quickly to keep up. A student ordering a second cup of coffee in a cafe might find that the price— already inflated at 5,000 marks—had gone up since he ordered the first cup. Such an extreme and rapid rise in prices is known as hyperinflation. At the peak of Germany’s hyperinflation, cash was plentiful but so worthless that people burned money in their woodstoves instead of wood. The German economy was indeed very sick. The United States has never gone through a period of hyperinflation, but economists are well aware of its devastating effects. They know that even ordinary inflation can be a sign of economic ill health. That is why economists monitor inflation, as well as other aspects of the economy. In this lesson, you will learn how economists gather data about an economy. You will see how they use the resulting statistics, called economic indicators, to assess a nation’s overall economic health.

The kayaks on display here are each included in the United States’ GDP. However, the fiberglass, plastic, and nylon used to create the kayaks would not be counted in the GDP because their value is accounted for as a part of the kayaks’ total value.

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1. How Do Economists Measure the Size of an Economy? When economists study a country’s economy, they can look at it from two different perspectives. They can study the economic decision making of individuals, households, and firms—the field known as microeconomics. Or, as you will do in this lesson, they can study the workings of the economy as a whole, the focus of macroeconomics. One of the first questions that scholars in the field of macroeconomics ask is, “How big is the economy?” Gross Domestic Product: What an Economy Produces The main measure of the size of a nation’s economy is its gross domestic product, or GDP. GDP is an economic indicator that measures a country’s total economic output. In formal terms, gross domestic product is the market value of all final goods and services produced within a country during a given period of time. A steadily growing GDP is generally considered a sign of economic health. The job of measuring U.S. GDP belongs to the Department of Commerce’s Bureau of Economic Analysis. We can learn a lot about what is involved in this measurement by looking at the formal definition of gross domestic product phrase by phrase.

The market value . . . Our economy produces a vast variety of goods and services, everything from guitar lessons to computers. How can anyone add them all together to come up with a single measure of an economy’s output? The Bureau of Economic Analysis does so by attaching a market value to each product. Market value is the price buyers are willing to pay for a good or service in a competitive marketplace. Of all final goods and services . . . GDP is based on the market price of every “final” good or service that can be legally sold in a country. A final good is any new good that is ready for use by a consumer. A box of cereal is a final good, as is a new car. Goods that are used in the production of final goods, such as the grains used to produce cereal or the steel and rubber used to manufacture cars, are known as intermediate goods. Their market value is not counted in GDP because it is already included in the market value of the final good. Produced within a country . . . To be included in GDP, goods and services must be produced within the country’s borders. The firms that Level: A

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produce the goods and services do not necessarily have to be American owned. Cars manufactured in the United States by the Japanese automaker Toyota, for example, are included in the United States’ GDP.

During a given period of time. The Bureau of Economic Analysis calculates GDP every quarter, or three-month period. Economists use the calendar year GDP to compare production from year to year or from country to country. This annual GDP includes all final goods and services produced between January 1 and December 31. Goods do not have to have been sold during that period to be included in GDP. For example, a kayak manufactured in 2018 but sold in 2019 would be included in the 2018 GDP. How Economists Calculate GDP Economists typically calculate GDP by measuring expenditures on goods and services produced in a country. In order to do so, they divide the economy into four sectors: households, businesses, government, and foreign trade. Each sector’s spending makes up one of the four components of GDP: household consumption (C), business investment (I), government purchases (G), and the net of exports minus imports (NX). Economists calculate GDP using this formula: C + I + G + NX = GDP Figure 13.1A shows how this formula was used to calculate the United States’ GDP for the year 2017.

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Figure 13.1A Gross domestic product is a measure of the total output of an economy. The diagram shows U.S. spending in 2017 on the four components used to calculate GDP. The figures are in trillions of dollars. Note that household consumption is by far the largest component. Note also that net exports – exports minus imports – is a negative number. This indicates that Americans spent more on imports than they received for exports that year.

Household consumption, C. This component of GDP consists of goods and services bought by people in households for personal use. Household consumption ranges from food and fuel to movie tickets and medical care. Business investment, I. This component consists largely of business investment in capital goods, such as buildings and machinery. It also includes goods produced but not yet sold. Government purchases, G. Federal, state, and local government purchases of goods and services are also included in GDP. Economists do not count government transfer payments, such as welfare or Social Security benefits, as part of GDP. These payments do not create new production, nor do they involve the purchase of goods or services by the government. Net exports, NX. In calculating the impact of trade on GDP, economists focus on net exports—the value of all exports minus all imports. This makes sense because when a country exports goods and services, those exports bring money back home. The sale of these goods increases the exporting country’s GDP. Just the opposite happens, however, when a country imports goods and services. The Level: A

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money used to pay for these imports leaves the economy, thus decreasing the importing country’s GDP. Net exports can be either positive or negative. When exports exceed imports, net exports are positive and increase GDP. When imports exceed exports, net exports are negative and decrease GDP. Adjusting for Inflation: Nominal vs. Real GDP Economists use GDP figures to determine not only how big an economy is, but whether it is growing or shrinking and at what rate. For example, the GDP of the United States in 2016 was $19 trillion. The GDP in 2017 was $19.8 trillion. The difference between these two figures suggests that the economy grew by about $0.8 trillion, or 4.2 percent, from 2016 to 2017. However, is determining changes in economic output as simple as subtracting an earlier year’s GDP from a later year’s GDP? The answer is no, and the reason is inflation, which drives up the prices of goods and services over time. Simply calculating GDP by adding the spending on its four components yields what economists call nominal GDP. Nominal GDP measures the output of an economy valued at today’s prices, or in current dollars. Current dollars reflects the purchasing power of the dollars in the year they are spent. Using current dollars does not take the effect of inflation into account. Inflation can cause prices in current dollars to rise from year to year. And if prices go up, nominal GDP will increase over time, even if the actual output of the economy does not. To compensate for the effects of inflation, the Commerce Department calculates what is called real GDP. Real GDP measures the output of an economy not in current dollars, but in constant dollars. The value of constant dollars is fixed at a rate that was current in a specified base year. Because the purchasing power of constant dollars is fixed, real GDP allows us to compare the total output of an economy from year to year as if prices had never changed. In the example above, real GDP figures show that U.S. economic output grew by only 2.9 percent during 2017, not 4.2 percent as indicated by nominal GDP figures. Figure 13.1B compares nominal and real U.S. GDP over a period of several years.

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Figure 13.1B This graph compares nominal and real GDP over time. Nominal GDP measures output for the current year in current dollars. Real GDP measures this same output in constant dollars, the value of which is fixed at a base year, in this case 2009. Constant dollars are adjusted for inflation, so figures for real GDP are less than those for nominal GDP. • Note that nominal GDP rose from $14.4 trillion to $19.8 trillion over eight years, about a 38 percent increase. • Real GDP, in contrast, rose from $14.4 to $17 trillion, an increase of only 18 percent.

Adjusting for Population: Per Capita GDP Economists also use GDP to compare the economies of individual countries. To make accurate comparisons, economists must adjust GDP yet again. This time they do so to take population size into account. Adjusting for population is accomplished by calculating per capita GDP. Per capita means “per person.” Per capita GDP is a nation’s real gross domestic product divided by its population. It is an accepted measure of a society’s standard of living. Level: A

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Consider the United States and Norway, for example. In 2017, the nominal GDP of the United States was about $19.8 trillion. This was more than 54 times the size of Norway’s GDP of $0.37 trillion.

When the trees that were taken from this forest are sold as lumber, their value will be included in GDP. However, GDP will not reflect the negative spillover effects often associated with logging. Such effects include the loss of a valuable resource, habitat loss, and soil erosion.

The difference is not surprising, considering that the U.S. population was more than 325 million and that of Norway just over 5 million. A country with more people generally produces more goods and services, thus resulting in a higher GDP. As this example shows, size alone does not provide a complete picture of a country’s economy. This is why economists use per capita GDP to compare one nation to another. In 2017, the per capita GDP of the United States was about $59,800. The per capita GDP of Norway was about $72,100. Despite having a much smaller economy, Norwegians had a higher standard of living than Americans did. Limitations of GDP as an Indicator of Economic Health Gross domestic product is a useful tool for measuring economic growth. But as a measure of the overall health of an economy, GDP has several limitations.

GDP leaves out unpaid household and volunteer work. Unpaid activities can have value. For example, a volunteer firefighter and a 2020 Teachers' Curriculum Institute

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parent who stays home to raise children are both doing important work. But because no money is exchanged, such work does not show up in a country’s GDP.

GDP ignores informal and illegal exchanges. GDP statistics do not count informal or illegal economic activity as part of a nation’s output. An informal economy is one that operates without government regulation. Occasional babysitters, for example, are paid for their work, but such transactions are not counted as part of a country’s GDP. Barter is another type of informal exchange that is not reflected in GDP. GDP counts some negatives as positives. A rise in GDP is not always a good sign. For example, after a hurricane, rebuilding can generate economic activity, which in turn can boost GDP. But people are still far worse off than they would have been if disaster had not struck. Over-exploitation of natural resources can also boost GDP. For example, cutting down a rainforest will raise GDP in the year of the harvest, but this temporary rise is no guarantee that people will be better off in the future without that resource. GDP ignores negative externalities. GDP does not reflect the impact of negative externalities such as pollution. A rapidly industrializing country like China, for example, can have a rising GDP even as water and air quality decline. Moreover, GDP turns a negative into a positive when money is spent in response to environmental damage. For example, if a chemical spill from a factory contaminates a drinking well, people’s increased purchases of bottled water are added to GDP. GDP places no value on leisure time. Citizens of industrialized nations today enjoy more free time than ever before. This leisure time is a major benefit of living in a modern economy. Yet, because time is not sold in markets, it is not reflected in GDP. GDP says nothing about income distribution. A high per capita GDP may suggest that everyone in a society receives a fair share of goods and services. But per capita GDP is an average. It tells us nothing about how income is distributed in a society. Saudi Arabia, for example, has a high per capita GDP but huge income gaps between its richest and poorest citizens. As this list of limitations suggests, there is much that GDP does not tell us about a society’s economic welfare. As Robert Kennedy once observed, [GDP] is indifferent to the decency of our factories and the Level: A

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safety of our streets alike. It does not include the beauty of our poetry or the strength of our marriages, or the intelligence of our public debate or the integrity of our public officials . . . It measures everything, in short, except that which makes life worthwhile. —Senator Robert Kennedy, 1968 How GDP Growth Makes People Better Off For all of its limitations, GDP still matters. As a country’s per capita GDP increases, so too do other indicators of well-being, such as those listed below.

Literacy and education. Studies show that countries with a high per capita GDP have high levels of education. The literacy rate—the percentage of people in these countries who can read and write—is at or near 100 percent. Literacy rates are much lower in countries with low per capita GDP. People with more education generally have better jobs and higher incomes than people with less education. Health and life expectancy. GDP is related to the health of a population. One measure of health is life expectancy—the number of years, on average, that a person is expected to live. People tend to live longer in countries with high per capita GDP than in countries with low per capita GDP. Another measure of health is infant mortality—the rate at which babies die during their first year of life. Because people in wealthier countries have better medical care and nutrition, infant mortality rates are lower in countries with high per capita GDPs. Standard of living. Not surprisingly, people in countries with high per capita GDP tend to be more prosperous than people in low-GDP countries. Their houses are bigger and more comfortable. They have more food and clothing and better access to services. While such material prosperity is surely no guarantee of individual happiness, overall, people are better off living in a society with a high standard of living.

2. What Does the Unemployment Rate Tell Us About an Economy’s Health? At any one time, millions of Americans may be out of work. For many of 2020 Teachers' Curriculum Institute

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them, the experience is devastating. They struggle to pay bills and to put food on the table. In hard economic times, such as a recession, the number of people who are unemployed rises. When business is booming, the number falls. The job of tracking unemployment belongs to the Bureau of Labor Statistics (BLS). The BLS is a government agency that collects and analyzes economic data. This agency determines the unemployment rate—the percentage of the labor force that is seeking work. Like GDP, the unemployment rate is a useful indicator of the health of an economy. In general, a high unemployment rate means that the overall health of the economy is poor. How the Government Measures Unemployment Every month, the BLS reports the total number of people who were unemployed for the previous month. To arrive at this figure, the BLS does not attempt to count every job seeker in the country. Instead, it conducts a sample survey each month. By examining a small, but representative, sample of the population, the BLS can gauge how many people in the entire population are unemployed. The BLS surveys about 60,000 households each month. Household members who are eligible to be in the labor force are interviewed about their activities during a specific one-week period. The survey excludes those who are under 16 years of age, on active duty in the military, or in an institution such as a prison or nursing home. Based on the interview data, the BLS classifies those who are eligible as employed, unemployed, or not in the labor force.

Employed. Members of the labor force who have jobs are classified as employed. This category includes people who worked for at least one hour for pay or profit during the survey week. It also includes those who worked 15 hours or more without pay in a family-operated business. And it includes workers who were sick, on vacation, or otherwise excused from their jobs during the survey week. Unemployed. Members of the labor force who are jobless, but are looking for work, are classified as unemployed. To be counted as unemployed, individuals must have actively looked for work in the four weeks preceding the survey week. There is an exception: people who have been laid off and are waiting to be called back to their jobs do not need to actively seek work to be counted as unemployed.

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Figure 13.2A The Bureau of Labor Statistics classified people who are eligible to participate in the labor force as employed, unemployed, or not in the labor force. It then uses these figures to determine the unemployment rate. • To calculate the size of the labor force, add the number of employed workers to the number of unemployed workers. • To calculate the unemployment rate, divide the number of unemployed workers by the number of people in the labor force.

Not in the labor force. Everyone who is eligible to be in the labor force but is neither working nor looking for work is classified as not in the labor force. This category includes full-time students as well as people who are retired, disabled, or prevented by family responsibilities from taking a paying job. The BLS adds together the number of employed and unemployed people to determine the size of the labor force. To calculate the 2020 Teachers' Curriculum Institute

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unemployment rate, it then divides the number of unemployed people by the number in the labor force. The result is multiplied by 100 to express this ratio as a percent, as shown in the formula below. number unemployed unemployment rate = number in labor force x100 Figure 13.2A shows how this formula applies to a specific example, drawn from the results of one BLS survey conducted in February 2018. Four Types of Unemployment In its interviews, the BLS gathers detailed information about people who are unemployed. Based on those data and further research, economists identify four types of unemployment: frictional, structural, seasonal, and cyclical.

Frictional unemployment. Have you ever heard someone talk about being “between jobs”? This situation, which exists when a person has left one job and is looking for another, is what economists call frictional unemployment. It applies to people who change jobs as well as to people seeking their first job. Frictional unemployment is usually short term, lasting only as long as is needed to find the right job. Consider Devin, who worked for a year in the electronics department of a retail store at the mall. Though he excelled at his job, he was unable to get a promotion. So, he quit because he was confident he would be able to find a better position at a big electronics store. Frictional unemployment like Devin’s can create temporary hardship for the jobless person. It also represents lost production for an employer trying to fill a position. However, a certain amount of frictional unemployment is unavoidable when people are free to change jobs at will. Changing jobs is usually good for the economy because it can reallocate labor resources to their best use.

Structural unemployment. People who choose to change jobs are in transition. Their skills are still in demand and the time they spend without a job is usually short. The same cannot be said of those who experience structural unemployment. Structural unemployment comes about mainly when advances in technology reduce the demand for certain skills. Megan, for example, worked as a travel agent for 20 years. She loved her job—until the internet came along. Online travel services made it easy for people to plan their trips themselves. The demand for Megan’s Level: A

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skills decreased. Her job was eliminated, and she became unemployed.

What can people like Megan do to become employable again? They might consider returning to school to develop new skills that employers want, or they might be able to adapt existing skills to qualify for new job opportunities. Even though structural unemployment is hard on those who experience it, the economy as a whole clearly benefits from the technological progress that creates it.

Seasonal unemployment. In some markets, demand for labor depends on the season. For example, Taylor works for a small construction company in Montana. Winters in Montana are so cold that her company almost always closes during January and February. For two months, Taylor experiences seasonal unemployment. Seasonal unemployment occurs when businesses shut down or slow down for part of the year, often because of weather. Tourism, construction, and agriculture are among the industries that typically lay people off for part of the year.

Cyclical unemployment. Every economy goes through prosperous times and hard times. Such cycles of growth and decline are the cause of cyclical unemployment. This type of unemployment occurs during periods of decline. At such times, economic activity slows, GDP drops, and people lose their jobs. 2020 Teachers' Curriculum Institute

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Consider Kai, who in the late 1990s worked as a web designer for a start-up company that sold pet supplies over the internet. Like many other internetbased start-ups—or dot-coms—the company had no trouble attracting investors who were convinced that doing business over the internet was the wave of the future. The company’s stock soared in value, even though the business itself wasn’t making a profit. During this period, the price of dot-com stocks rose to dizzying heights. Then, in 2000, the dot-com bubble burst. Investors rushed to sell off their dot-com shares, and the value of those stocks dropped dramatically. The company that employed Kai went out of business, leaving him and his co-workers unemployed. People like Kai who experience cyclical unemployment often have trouble finding new jobs that use their skills. Few businesses hire new workers during an economic decline. Moreover, the labor market may be overwhelmed with equally qualified workers who are in the same situation. Many people are forced to take jobs outside of their chosen fields or live on unemployment benefits while they wait for the economy to improve. Full Employment and the Natural Rate of Unemployment When an economy is healthy and growing, it experiences little cyclical unemployment. But there will always be some frictional, seasonal, and structural unemployment. Some people will always be out of work, even in an economy with full employment. At that point, all of the economy’s available labor resources are being used efficiently.

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Figure 13.2B This graph shows the ups and downs in the unemployment rate over several decades. The horizontal band shows the natural rate of unemployment during the same time period.

When an economy reaches full employment, jobs exist for everyone who wants to work, even though a certain percentage of those jobs and workers will not yet have been matched together. Economists call this percentage the natural rate of unemployment . This rate has varied historically, but has generally ranged between 4 and 6 percent. Figure 13.2B shows unemployment rates over time. Problems with the Unemployment Rate as an Indicator of Economic Health In determining how many of the country’s more than 320 million people are unemployed, the BLS makes every effort to be accurate. Still, critics point to several problems that may make the results less than exact. The first problem is that at any one time, a number of unemployed people have given up looking for work. Though willing and able to work, they no longer expect to find jobs. These discouraged workers do not fit the BLS’s definition of unemployed, which counts only those individuals who are making an effort to find work. Because discouraged workers are left out of BLS calculations, the official unemployment rate is too low. The second problem is that the official unemployment rate does not recognize involuntary part-time workers. These are people who, 2020 Teachers' Curriculum Institute

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unable tofind full-time jobs, settle for part-time employment. They work less than 35 hours per week. Others who once worked full time may have had their hours cut back. The BLS counts such part-time workers as employed. However, some economists think these workers should be counted as partially unemployed. For example, someone who works 20 hours a week but wants full-time work might be counted as “half unemployed.” A third problem with the unemployment rate involves people working in informal or underground economies. The underground economy is made up of people who earn income from gambling, drug dealing, and other illegal activities. When surveyed by the BLS, they would be unlikely to admit to anything illegal. Instead, their answers would suggest they are unemployed. The same might be true for people in the informal economy who pay no taxes on their earnings. As a result, the actual rate of unemployment might be lower than the official rate indicates.

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Figure 13.2C Some groups of Americans have higher unemployment rates than others. Workers who are less skilled or less educated are more vulnerable to job loss than those with more skills and experience. Teenagers have the highest unemployment rate, in part because they have fewer skills and less experience than adults. This graph shows a teenage unemployment rate of 12.5 percent in 2018.

The Economic Costs of High Unemployment Despite its flaws, the official unemployment rate serves as a fairly good indicator of conditions in the labor market. And in general, when the rate is high, the overall health of the economy is poor. The main economic cost of high unemployment is lost potential output. The smaller the number of people who are working, the fewer goods and services the economy can generate. Potential output is lost because labor resources are not being fully utilized. An increasing unemployment rate, then, means a decreasing real GDP. Unemployed workers also pay a serious economic cost. They and their families lose income and the goods and services that income would have purchased. They may become unable to pay their monthly mortgage, leading to the loss of a home. Unemployment can also mean the loss of medical benefits, which then become an added expense. 2020 Teachers' Curriculum Institute

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High unemployment is also costly for society at large. Unemployed workers no longer contribute income taxes to the government. In fact, many begin taking money from the government in the form of unemployment insurance and other benefits. This may call for shifting money from other programs to pay the additional benefits, or it may mean raising taxes on workers who remain employed.

3. What Does the Inflation Rate Reveal About an Economy’s Health? Germany’s experience with hyperinflation after World War I was proof that runaway inflation can send an economy into a tailspin. That is why economists keep a close eye on a third economic indicator: the inflation rate. The inflation rate is the percentage increase in the average price level of goods and services from one month or year to the next. It is also tracked by the Bureau of Labor Statistics. Tracking Inflation with the Consumer Price Index The BLS tracks inflation by gathering information on Americans’ cost of living, or the goods and services that households like yours purchase every day. The cost of living changes all of the time because prices do not stay the same. Economists track changes in the cost of living using what is known as the consumer price index. A price index measures the average change in price of a type of good over time. The consumer price index (CPI) is a price index for a “market basket” of consumer goods and services. Changes in the average prices of these items approximate the change in the overall cost of living. For that reason, the CPI is sometimes called the cost-of-living index. It serves as the primary measure of inflation in the United States. The CPI market basket is based on surveys of thousands of households, which are used to develop a detailed list of items to track. Each month, BLS data collectors visit some 25,000 retail stores and record the prices of these items. The BLS determines the CPI by comparing each month’s price information to the prices paid for the same goods and services during a base period. As of 2017, the base period was 1982–1984. The BLS set the cost of goods and services in its market basket during that period Level: A

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at 100.

Using its monthly price data, the BLS can track the change in the CPI between any two periods. For example, the CPI for May 2016 was 239.439, but by May 2017, the CPI had increased to 243.911. Based on those numbers, the BLS calculates that the CPI rose 1.8 percent during that 12-month period. In other words, the inflation rate for that oneyear period was 1.8 percent. Adjusting for Inflation: Nominal vs. Real Cost of Living You have surely heard older people complaining about how prices have gone up since they were young. A pair of shoes that once cost $4, for example, cannot be purchased for less than $40 today. But do higher prices really mean that things cost more? The price a person pays for a pair of shoes or any other product is its nominal cost, or its cost in current dollars. The cost in current dollars of all the basic goods and services that people need is the nominal cost of living. Like the nominal GDP, the nominal cost of living is based on current prices. The real cost of living is the nominal cost of basic goods and services, adjusted for inflation. Knowing the rate of inflation allows economists to calculate the real cost of goods and services in constant dollars. The 2020 Teachers' Curriculum Institute

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real cost of living can then be used to compare prices over time. People who complain about how much prices have risen over the years are probably not thinking about the other side of the coin—wages. Consumers pay nominal costs with nominal wages , or wages based on current prices. As prices go up, wages generally go up as well. By using the CPI to adjust for inflation, economists can calculate real wages and compare them over time. Figure 13.3A, which tracks presidential salaries since 1789, illustrates the difference between nominal wages and real wages adjusted for inflation.

Figure 13.3A The first Congress set George Washington’s salary as president at $25,000 a year. Two centuries and many pay hikes later, current presidents receive $400,000 a year. The difference seems enormous until the effects of inflation are taken into account. When real wages are compared – based on constant 2018 dollars – Washington comes out as the better-paid leader. As a fairly wealthy man, however, Washington declined to accept any salary as president.

If wages keep pace with the cost of living, perhaps things do not really cost more than they used to. Thanks to this upward trend, the shoes once purchased for $4 were affordable then and may be just as affordable today at $40. Looking at the cost of living in terms of time, not money, supports this conclusion. As noted in a 1997 Federal Reserve report,

The cost of living is indeed going up—in money terms. What really matters, though, isn’t what something costs in money; it’s what it costs in time. Making money takes time, so when we shop, we’re really spending time. The real cost Level: A

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of living isn’t measured in dollars and cents but in the hours and minutes we must work to live. So how does the cost of a $4 pair of shoes in 1958 compare to the cost of a $40 pair of shoes 50 years later? In 1958, the average wage was around $2 per hour. In 2018, wages averaged around $22 per hour. The two pairs cost about the same—around two hours of time worked. Creeping Inflation, Hyperinflation, and Deflation In an ideal world, prices would be stable, neither rising nor falling over time. In our real world, prices are always changing. The result can be creeping inflation, hyperinflation, or deflation.

Creeping inflation. In the United States we have come to expect a certain amount of gradual inflation, or creeping inflation, every year. Since 1913, the average annual rate of inflation has been about 3.2 percent. For much of that period, the rate has varied widely. But during your lifetime it has stayed fairly close to that average. For Americans, this is normal inflation—the level of inflation that we are used to.

Hyperinflation pushed the economy of Zimbabwe to the point of collapse. At one point, the banks even printed one hundred trillion dollar notes. These notes were only worth about five U.S. dollars.

Hyperinflation. Occasionally inflation goes into overdrive. The result is hyperinflation. Runaway inflation creates extreme uncertainty in an economy. Nobody can predict how high prices will go, and people lose confidence in their currency as a store of value. A number of countries have experienced hyperinflation since Germany in the 1920s. The African country of Zimbabwe is one example. Zimbabwe began its plunge into crisis in 2000, when the government 2020 Teachers' Curriculum Institute

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seized thousands of farms. Foreign investors fled. Unemployment shot up. Food shortages became severe. The government responded to the crisis by printing money, adding trillions of Zimbabwean dollars to the money supply each year. As the Zimbabwean dollar lost value, inflation skyrocketed. Vending machines that took coins quickly became unusable. One soda would have required the deposit of billions of coins. By June of 2008, the official annual inflation rate had topped 230,000,000 percent. With the price of goods doubling every few days, farms and factories shut down and standards of living collapsed.

Deflation. The inflation rate is usually a positive number, meaning that the overall price level is rising. But the inflation rate can be negative, a condition that economists call deflation. Deflation occurs when prices go down over a period of time. Deflation is good news for consumers and savers. The value of every dollar they set aside now to spend later will increase over time as prices fall. Deflation is also good for lenders. The dollars they receive from borrowers tomorrow will be worth more than the dollars they lent them yesterday. This increase in the value of dollars can be painful for borrowers, however. Deflation may also be bad news for businesses. When prices are dropping, people tend to put off spending, hoping for still lower prices later on. As consumer spending slows, businesses cut wages, lay off workers, and may even go bankrupt. The result can be a deflationary spiral, such as occurred in the early days of the Great Depression. In a deflationary spiral, falling prices lead to business slowdowns, which lead to lower wages, which lead to still lower prices, and so on. Demand-Pull vs. Cost-Push Inflation You are already familiar with one cause of inflation: an increase in the money supply. A dramatic increase in the amount of money in circulation can cause hyperinflation. But even a more modest increase may trigger inflation if the result is too many dollars chasing too few goods. A second cause of inflation is an increase in overall demand. The spending that makes up GDP comes from households, businesses, government, and foreign buyers. Sometimes these four sectors try to purchase more goods and services than the economy can produce. This increase in overall demand results in demand-pull inflation, which exerts a “pull” on prices, forcing them up. Inflation can also be caused by increases in the cost of the factors of Level: A

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production. Higher production costs reduce the economy’s ability to supply the same output at the same price level. The result is cost-push inflation. The rising cost of land, labor, or capital “pushes” the overall price level higher. Cost-push inflation is often triggered by increases in energy prices. Rising fuel costs affect every link in the supply chain, from farms and factories to the delivery of goods to retail stores. The higher costs of making and moving goods are then passed on to consumers in the form of higher prices. Whether caused by increased demand or rising costs, inflation can set off a “feedback loop” known as a wage-price spiral. This spiral starts when workers demand higher wages in order to keep up with inflation. Employers pay the higher wages but then raise prices still higher to cover their increased production costs. Higher prices for goods and services once again decrease the real income of the workers, prompting them to call for still higher wages. As their demands are met, wages and prices keep climbing in an inflationary spiral. Limitations of the CPI as a Measure of Inflation The BLS relies on the consumer price index to estimate the level of inflation in the United States each month. However, critics point to several biases that may distort the CPI, making the reported inflation rate less than accurate.

Substitution bias. Because the CPI measures the price changes of a fixed list of goods, it does not take into account consumers’ ability to substitute goods in response to price changes. For example, when the price of beef rises, many people buy chicken instead. Such savings are not reflected in the CPI. Outlet substitution bias. The CPI is slow to reflect changing trends in shopping patterns. For example, a growing number of households shop at discount stores, buying clubs, and superstores. The money saved by consumers who shop at these low-cost outlets may not be reflected in the CPI. New product bias. In a market economy, new products are introduced all the time. Because the BLS cannot predict which new products will succeed, the new products are not incorporated into the market basket until they have become commonplace. For example, the mobile phone was introduced in 1983. However, it was not included in the CPI until 1998. By that time, the price of mobile phones had dropped from $3,995 to under $200. None of these pre-1998 price drops were reflected in the CPI. 2020 Teachers' Curriculum Institute

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Figure 13.3B A wage-price spiral is a vicious cycle in which rising prices drive up wages and then rising wages drive up prices. The result is an inflationary spiral that can be hard to break.

Quality change bias. Over time, technological advances may improve the quality or add to the lifetime of a product. An example is the automobile tire. Tires today generally last longer than they did in the past. As a result, the cost of tires on a per-mile basis has dropped. Because drivers buy tires less often, longer-wearing tires save money. But these savings are not reflected in the CPI. The BLS has taken steps to reduce such biases through increasingly sophisticated methods of gathering data. Even so, some economists have estimated that, taken together, these biases in the CPI cause the Bureau of Labor Statistics to overstate the annual inflation rate by as much as 1 percent. Thus, the economy may actually be healthier—and Americans better off—than the CPI suggests. The Economic Costs of Inflation Between 2000 and 2017, the annual rate of inflation in the United States ranged from a low of –0.4 percent to a high of 3.8 percent. Whether inflation at these relatively low levels is “healthy” for the economy is open to debate. But inflation of any amount exacts economic costs.

Loss of purchasing power. Inflation erodes purchasing power—the amount of goods and services that can be bought with an amount of money. It undermines one of the basic functions of money: its use as a store of value. For example, suppose you have your eye on an electric guitar that costs $200. When you go back to the store, you discover that the guitar now costs $220. It is the same guitar, but inflation has pushed the price up by 10 percent. The purchasing power of your $200 has eroded by 10 Level: A

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percent. Multiply this single example across an entire economy and you can see how inflation could affect people’s standard of living. Retired people living on fixed incomes are the hardest hit by a continual increase in the overall price level. Working people have less to worry about. As long as wages keep pace with inflation, workers will not lose purchasing power.

Higher interest rates The expectation that inflation will erode future purchasing power drives up interest rates. In inflationary times, lenders pay close attention to the real interest rate on the money they loan. The real interest rate is the nominal interest rate minus the inflation rate. Higher real interest rates on bank deposits provide an incentive for people to save more. But higher real rates also slow economic growth by making loans too costly. Lower real interest rates discourage saving but encourage borrowing.

Loss of economic efficiency. Many economists consider uncertainty about prices to be a bigger problem than loss of purchasing power or higher interest rates. When prices fluctuate due to inflation, buyers and sellers cannot rely on an increase or decrease in prices to give them clear information about market conditions. By making price signals harder to interpret, inflation reduces market efficiency.

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Figure 13.3C Because of inflation, the dollar you hold today may not have as much purchasing power tomorrow. This “backpack index” shows the effect of 3 percent inflation on the prices of some everyday items over time.

4. How Does the Business Cycle Relate to Economic Health? Economies are always changing. Or, as economics writer Charles Wheelan puts it, they “proceed in fits and starts.” Wheelan is referring to the recurring periods of growth and decline in economic activity that all economies experience. Economists call this recurring pattern the business cycle. The Four Phases of the Business Cycle The business cycle consists of four phases. These phases include a period of growth and a period of decline, as well as the turning points that mark the shift from one period to the next. A period of economic growth is known as an expansion. During this phase of the business cycle, economic activity generally increases from month to month. The longest expansion of the U.S. economy lasted over decade, but expansions typically run out of steam in three to five years. The point at which an expansion ends marks the peak of the business Level: A

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cycle. At that peak, economic activity has reached its highest level. The peak also marks the start of a decline in economic activity. Economists do not know when a peak is occurring until they look back at the economic data. At that time, they designate one month as the peak phase. Following the peak comes the contraction phase of the business cycle. A contraction is a period of general economic decline marked by a falling GDP and rising unemployment. One of the longest contractions on record—43 months—occurred at the start of the Great Depression. Since 1945, however, contractions have averaged about 10 months. The lowest point of a contraction is called the trough. Like the peak, the trough marks a turning point. Once the economy hits bottom, a new expansion period begins.

The construction of new homes, like the one shown here, can be an indicator of economic health. More homes being built indicates that people are confident that economy will continue to grow and improve.

Economic Indicators and the Business Cycle The term business cycle implies that expansions and contractions occur at regular, predictable intervals. But in fact, the opposite is true. Business cycles are irregular in both length and severity. This makes peaks and troughs difficult to predict. Nonetheless, economists attempt to do just that, using a variety of economic indicators, such as GDP, inflation rate, and unemployment rate. 2020 Teachers' Curriculum Institute

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Economists categorize the indicators they use to track the business cycle based on whether they signal a future change, an ongoing change, or a change that has already begun.

Leading indicators. Measures that consistently rise or fall several months before an expansion or a contraction begins are called leading economic indicators. They are used to forecast the peak and trough of a business cycle, although not very precisely. The Census Bureau’s monthly estimate of housing starts is one such leading indicator. It shows the number of new home-construction projects started in the previous month. A rise in housing signals that there is enough money and confidence in the economy to begin preparing for the next expansion. As the economy improves, there will be plenty of people eager to buy new homes. A decline in housing indicates trouble ahead as consumers grow more cautious about buying new homes.

Coincident indicators. Coincident economic indicators are measures that consistently rise or fall along with expansions or contractions. They coincide with the phases of the business cycle. Coincident indicators are most helpful in tracking expansions and contractions as they happen. One of the most reliable coincident indicators is real GDP. As a rule, if total output is increasing in real terms month after month, an economy is expanding, but if total output begins to shrink, the economy is contracting. Because inflation also tends to rise and fall with economic activity, economists use the inflation rate as an important coincident indicator as well.

Lagging indicators. Measures that consistently rise or fall several months after an expansion or a contraction are known as lagging economic indicators. Economists use lagging indicators to confirm that one phase of the business cycle has ended and another has begun.

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One of the most important lagging indicators is the unemployment rate. The reason for this is that firms are often reluctant to make decisions to lay off or hire workers until they are sure about the direction of the economy. For example, when an expansion begins, firms may delay hiring new workers until they know that the economy is really growing. As a result, unemployment rates do not drop until weeks or months after an economy hits its low point and begins to recover. From Boom to Bust to Boom Again Business cycles are popularly known as periods of boom and bust. A boom is the expansion phase of the cycle. It may also be known as a recovery, upturn, upswing, or period of prosperity. All of these terms mean the same thing—the economy is healthy and growing. One of the key characteristics of a growing economy is an increase in business investment. When firms invest in capital goods, such as factories, machinery, and equipment, their productivity increases. This increased productivity contributes to a rise in real GDP. At the same time, firms hire more people to work in their stores, offices, and factories, thus increasing employment throughout the economy. 2020 Teachers' Curriculum Institute

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Other factors can also contribute to growth. The discovery of new resources, such as by drilling or mining, can boost the quantity of raw materials available for production. Innovations in science or technology can improve efficiency and increase productivity. Such positive “shocks” to the economy can stimulate an expansion. Consumer confidence is typically high during an expansion since jobs are plentiful and both business profits and wages are rising. The future looks bright, leading consumers to borrow and spend money, especially on “big ticket” items such as cars, appliances, and furniture. An economic expansion can go on for years, leading people to think that it might go on forever. But inevitably, boom turns to bust. The bust, or contraction phase of the business cycle, is also called a downturn, a downswing, or a recession. Most economists define a recession as a decline in economic activity lasting at least six months. During a recession, real GDP falls, as do real wages, employment, profits, and production. Why does an expanding economy stop growing and start shrinking? There is no single answer to that question. A number of different obstacles to growth can push an economy into recession. They include a negative shock to the economy, such as rapidly rising oil prices, a terrorist attack, or a stock market crash. a rise in interest rates, which makes it harder for consumers and firms to borrow money. shortages of raw materials, which can cause price increases.

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America’s entry into World War II pulled the nation out of the Great Depression, the worst economic downturn in U.S. history. The war caused an immediate upsurge in demand for fighter planes, ships, arms, and supplies for the troops. This demand spurred an increase in production. Factories started hiring, unemployment fell, and an economic recovery began.

Consumers typically react to higher prices and higher interest rates by cutting back on spending. As sales slow, businesses begin to see profits fall and inventories rise. Inventory is merchandise that companies or stores have on hand. Faced with rising inventory, firms cut back production and lay off workers. If profits continue to fall despite these adjustments, firms must cut back further. In this way, an economy enters a contraction phase. Some recessions are short and relatively mild in their effects. Others are severe. On rare occasions, a recession will last a long time and cause serious damage to the economy. Economists refer to this kind of severe contraction as a depression. A depression is a prolonged economic downturn characterized by a plunging real GDP and 2020 Teachers' Curriculum Institute

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extremely high unemployment. Americans have suffered through several depressions, including the Great Depression of the 1930s. For many people, a recession is a time of anxiety about the economy and their own financial futures. How do consumers regain confidence? What brings bust back to boom? The answer may depend on the severity of the contraction. It took a war to end the Great Depression. The demand for armaments and other goods to fight World War II spurred production and finally turned the slumping economy around. Recoveries are usually triggered by a combination of events. As business inventories shrink over time, firms begin to increase production. Hiring begins to pick up. Optimism returns and consumers start spending again. A new expansion begins. The ups and downs of the business cycle may hold little interest for you at this point in your life. This is likely to change once you enter the job market. Should you start looking for work during an expansion, you may find many employers eager to hire you. But should you start your job search during a recession, good jobs may be hard to find. The next lesson explores what the government can—and cannot—do to smooth out the bumps in the business cycle.

Summary Economists use various indicators to measure the health of an economy. Three key economic indicators are a country’s gross domestic product, unemployment rate, and inflation rate. These and other indicators help economists figure out the economy’s position in the business cycle. How do economists measure the size of an economy? Gross domestic product (GDP) is the main measure of an economy’s overall size. Nominal GDP is the measure of the current year’s total output. Real GDP measures total output adjusted for inflation. Per capita GDP measures a country’s average output per person, allowing for countryto-country comparisons. What does the unemployment rate tell us about an economy’s health? People who do not have jobs but who are looking for work are officially unemployed. A rising unemployment rate is usually associated with an unhealthy economy. What does the inflation rate reveal about an economy’s Level: A

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health? Inflation is a rise in the overall price level. Economists use the Consumer Price Index (CPI) to determine changes in the price level from one period to another. A strong economy is likely to have a low level of inflation. A high inflation rate indicates an unhealthy economy. How does the business cycle relate to economic health? The business cycle consists of four phases: expansion, peak, contraction (or recession), and trough. As measured by real GDP, the economy grows during an expansion and shrinks during a contraction. The peak marks the end of an expansion and the start of a contraction. The trough marks the end of a contraction and the start of a new expansion.

Various Factors That Influence GDP Within the economy, there are numerous factors that can cause fluctuations to GDP. GDP—gross domestic product—is an economic indicator that measures the economic output of a country. Let’s explore some of the various factors that can impact GDP. Self-Interest Self-interest was an idea put forth by Adam Smith in The Wealth of Nations. Self-interest refers to the notion that consumers will behave in a way that puts themselves before others. However, Smith argues that this behavior instead has inherent benefits for the rest of society. As a result, self-interest can lead to economic benefits and a healthy, growing economy. Competition As you read, competition is the hallmark of the free enterprise system. Competition helps to incentivize businesses to create new and better products for consumers. The result is numerous goods and services for a consumer to choose from. Competition also motivates producers to lower production costs, thus lowering prices for consumers as well. Competition can therefore lead to higher GDP, as it encourages continued production of numerous and affordable goods for consumers, which in turn leads to economic growth. Collusion Collusion occurs when producers convene and make agreements on 2020 Teachers' Curriculum Institute

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production levels or pricing. However, collusion is illegal as it unfairly limits competition. This can affect GDP and the economy as limits on competition can lead to monopolies and prices that do not accurately reflect the market. Collusion can also hurt competition, which as you read above, is a key factor in economic growth. Technological Advancement Countries with higher GDPs tend to be more technologically advanced than lower GDP countries. This is because technological advancement can have a major impact on the production of goods and services. Increased usage of technology can lead to more efficient production, thus leading to a decrease in the costs of production. As a result, more products are produced at a cheaper price. Low production costs then translate to lower costs for consumers, thus encouraging purchase of those products. The cycle continues, causing growth in the economy. Standard of Living The standard of living within a country and GDP tend to correlate. People in countries with high per capita GDP tend to be more prosperous than those in low-GDP countries, including larger and more comfortable houses, more food, and access to better services. People are often better off living in a society with a higher standard of living as well. The Business Cycle The business cycle represents patterns of growth in decline within an economy, and consists of four phases: expansion, peak, contraction, and trough. The economy peaks when it has reached its highest level of economic activity. At this time, a country's GDP is likely high as the economy is prospering. Troughs are the lowest point of economic activity following a period of economic decline. It is after a trough that economic growth begins again. These phases are experienced by most economies, though it can be hard to predict when each phase will occur. Economists use a variety of economic indicators, such as GDP, the inflation rate, and the unemployment rate, to help predict periods of economic growth and decline.

The Impact of Inflation and Unemployment Level: A

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The United States economy is comprised of various sectors, or categories, of activity. The primary sector of the economy involves the extraction of natural resources and raw materials. This sector includes industries such as agriculture, fishing, mining, and timber. These products are then often sold to manufacturers in order to create a product. The secondary sector of the economy involves converting the raw materials and resources from the primary sector into products for consumers. The secondary sector more broadly covers the manufacturing industry, including automobile production, pharmaceuticals, and construction companies. The tertiary sector is often referred to as the service sector. This sector focuses on providing services rather than creating tangible goods and products. The tertiary sector therefore includes industries such as transportation, retail, education, and tourism. The U.S. economy is dominated by the tertiary sector. In 2010, 84% of the total U.S. economy was is involved in providing services. The United States continues to see an increasing trend on tertiary services—and a decrease in primary and secondary sectors. One reason for this decline points to U.S. reliance on other countries from which to import raw materials. United States companies also manufacture many products outside of the country, in countries such as China. Inflation and unemployment can have major effects on these sectors of the economy. Extremely high rates of inflation, called hyper-inflation, can lead to economic uncertainty and a loss of confidence in currency. Inflation can cause high prices of goods and services, which in turn can lead businesses and factories to shut down as the costs of production would also be too high. As a result, all three sectors of the economy would be damaged. Unemployment can also lead to a loss of economic output from all three sectors of the economy. The smaller the labor force, the fewer number of goods and services that can be generated by the economy. As a result, GDP and economic prosperity decreases. Processing math: 100%

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Fiscal and Monetary Policy How do policymakers use fiscal and monetary policy to stabilize the economy?

Vocabulary Glossary Vocabulary Cards fiscal policy monetary policy deficit spending stagflation multiplier effect easy-money policy tight-money policy crowding-out effect

Introduction

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The federal government and Federal Reserve System both work to keep the economy operating smoothly.

Economic news in 2008 was filled with gloom and doom. The year began with uncertainty that was caused by a meltdown in the housing market. After rising for years, home prices were dropping. Just how far they would plummet, no one knew. In most parts of the country, homes were worth less than they had been just months earlier—sometimes even less than their owners owed on their mortgages. Over the next few months, a significant rise in oil prices caused the price of gasoline to increase from approximately $3.00 a gallon to more than $4.00 a gallon. Drivers of large cars and trucks watched in horror as the cost of filling their gas-guzzlers crept to more than $100. The cost of food also rose at an alarming pace. Workers who used to go out to lunch began packing sack lunches at home to avoid soaring restaurant prices, and visits to food banks and soup kitchens increased as more people sought help in the face of rising living costs. Students returning to school in the fall saw the price of a cafeteria lunch go up by an average of 32 cents. Level: A

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Job losses and falling stock prices added to the country’s economic woes. Jobless workers, as well as those who feared for their jobs, cut back on spending. The resulting store closures and business bankruptcies created still more pain and uncertainty. By June 2008, the consumer confidence index, a measure of how people feel about their jobs and the economy, had sunk to a 16-year low. “If consumers are not spending, then the economy is in serious trouble,” said one economist when interviewed about the mood of the country. “I think we’re in a recession right now.” Years later, people in the United States and in other countries continued to face the consequences of the 2008 recession. “Recessions,” points out economics writer Charles Wheelan, “are like wars: If we could prevent them, we would. Each one is just different enough from the last to make it hard to ward off.” Moreover, once recessions begin, they tend to spread across borders. If jobless Americans, for example, stop buying German cars, Chinese toys, or Mexican oil, then the economies of those countries will also suffer. Who is responsible for monitoring the U.S. economy to prevent recessions, or, at the very least, to minimize the pain they cause? The answer today is the federal government and the Federal Reserve System (the Fed). The federal government uses fiscal policy, the government’s power to tax and spend, to get a stagnant economy moving again or to address inflation. The Fed uses monetary policy, a central bank’s control over the money supply and interest rates, to dampen inflation or to stimulate growth. This lesson explores how both approaches are used to stabilize the economy.

1. What Are the Origins of Modern Fiscal and Monetary Policy? Before the 1930s, the federal government rarely intervened in the economy, during good times or bad. The Great Depression, however, caused such widespread misery that when running for president in 1932, Franklin Delano Roosevelt promised he would no longer be bound by this hands-off approach. “I pledge you, I pledge myself,” FDR said, “to a new deal for the American people.” But just what this “new deal” should be and how it would end the Depression was not clear. Classical Economics and the Role of Government 2020 Teachers' Curriculum Institute

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Depression began, most U.S. economists belonged to a school of thought known as classical economics. Begun by Adam Smith, classical economics focused on the decisions of producers and consumers in a free market. Recessions were thought to be caused by events outside the market, such as wars and crop failures. Given time, the market would adjust and return to equilibrium. Classical economists believed that the government’s role in the economy should be minimal. These economists believed a government’s fiscal policy should focus on keeping taxes and spending low and balancing the federal budget. In their view, every tax dollar spent by the government was one less dollar spent by producers or consumers to stimulate business activity. The government’s borrowing to fund a budget deficit only made matters worse by sucking still more money out of the private sector. Roosevelt, like most politicians, accepted these views when the Depression began. During the 1932 presidential campaign, he blasted his opponent, President Herbert Hoover, for running a budget deficit. If elected, FDR promised to balance the federal budget. After taking office, he launched a flurry of new programs to get the economy moving again. But he never gave up trying to balance the budget—at least not until he encountered the ideas of a British economist named John Maynard Keynes.

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John Maynard Keynes revolutionized the way many thought about government’s role in the economy.

The Revolutionary Ideas of John Maynard Keynes Keynes looked at economics in a different way. Instead of focusing on the role of individuals in the marketplace, he studied the economy as a whole. In his landmark work, The General Theory of Employment, Interest, and Money, Keynes sought to explain why economies experience crises like a depression. He also discussed how political leaders could end the Great Depression and avoid similar crises in the future. Keynes’s basic idea was simple. During a recession, overall demand for goods and services decreases because people who are out of work stop spending. In response, businesses cut expenses and lay off workers. Some businesses even close their doors. When that happens, more people lose their jobs, depressing demand still further. The result is a downward economic spiral. The fastest way to break that downward spiral, Keynes argued, is for political leaders to use fiscal policy to increase overall demand. This increase could be achieved by cutting taxes, which would leave people with more money to spend, or it could be done by boosting government spending. To be effective, however, increased government spending 2020 Teachers' Curriculum Institute

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should be financed by borrowing money rather than by raising taxes. Higher taxes would only take more money out of consumers’ pockets.

Between 1933 and 1944, President Franklin Roosevelt delivered a series of 30 radio broadcasts. He often used these “fireside chats” to explain and urge support for his New Deal economic programs. Letters poured into Washington after each broadcast, putting pressure on lawmakers to enact the president’s proposals.

Taken together, these ideas form the basis of Keynesian economics. This school of thought holds that government intervention in the economy is the best way to ensure economic stability. If total spending by individuals and businesses is not enough to stimulate economic growth, then the government should step in to increase demand. Rising demand stimulates production. More production puts people back to work, so the economy begins growing again. Although widely accepted today, Keynes’s ideas were revolutionary in the 1930s. He rejected the view of classical economists, who believed that in the long run, the Depression would run its course and the economy would grow on its own. “This long run is a misleading guide to current affairs,” Keynes observed. “In the long run we are all dead.” Using Fiscal Policy to End the Depression In the early years of the Depression, Keynes had a hard time convincing political leaders to Level: A

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try out his ideas. He even paid a personal visit to Roosevelt in 1934, urging him to do more deficit spending to increase overall demand in the economy. Deficit spending occurs when a government spends more money than it collects in revenue. To finance such spending, governments often borrow money by selling bonds. When Roosevelt came out of his meeting with Keynes, he was more confused than convinced. “He left a whole rigmarole of figures,” the president complained to his secretary of labor. “He must be a mathematician rather than a political economist.” By 1938, however, Roosevelt was desperate. Despite his efforts to spark a recovery with government spending on public works and jobcreation programs, the Depression was deepening again. Reluctantly, FDR gave up trying to balance the budget and decided to give Keynes’s ideas a try. “We suffer primarily from a failure of consumer demand because of lack of buying power,” FDR said in a radio broadcast to the nation. “It is up to us [the government] to create an economic upturn.” Roosevelt went on to propose a multi-billion-dollar spending program, much of it to be funded by borrowed money. But even then, the economy was slow to respond. Only with the onset of World War II did the federal government pump enough money into the economy to end the Depression. Between 1939 and 1945, the federal budget deficit soared from under $3 billion to more than $47 billion due to deficit spending. At the same time, the unemployment rate dropped from 17 to 2 percent, while the nation’s gross domestic product (GDP) almost doubled. Postwar Economic Policy: “All Keynesians Now” Keynes died a year after World War II ended, but his ideas lived on in the Employment Act of 1946, which called on the federal government to keep the economy from sliding back into recession. The act did not specify how that was to be accomplished, but by then, most economists agreed with Keynes that the government could and should use its power to stabilize the economy. Keynesian economics was put to the test in the early 1960s, when growth slowed and unemployment began to rise. To halt the downward slide, President John F. Kennedy called on Congress to stimulate demand by cutting taxes. In an address laying out his plan, the president declared,

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The . . . best means of strengthening demand among consumers and business is to reduce the burden on private income . . . imposed by our present tax system . . . Too large a tax cut, of course, could result in inflation and insufficient future revenues— but the greater danger is a tax cut too little, or too late, to be effective. —John F. Kennedy, Address to the Economic Club of New York, Dec. 14, 1962 “I gave them straight Keynes,” Kennedy later said of this speech, “and they loved it.” Kennedy was assassinated before Congress acted on his tax proposal, but when finally enacted in 1964, the Kennedy tax cuts sparked a long period of economic expansion. Unemployment declined, just as Kennedy had hoped. At the same time, however, inflation began to rise. By the end of the 1960s, the idea that the government could use fiscal policy to fine-tune the economy to keep it balanced between inflationary booms and high unemployment busts was widely accepted. Even Richard Nixon, who had campaigned against “runaway government” in 1968, would proclaim after being elected president, “We are all Keynesians now.” Rise of Monetarism Within a few years, however, cracks began to appear in the Keynesian consensus. One of the most influential critics of Keynes was an American economist named Milton Friedman. Like Keynes, Friedman lived through the Great Depression, but he had a very different explanation for its causes and cure. Along with his coauthor Anna Schwartz, he laid out this explanation in the book A Monetary History of the United States, 1867–1960, published in 1963. Friedman and Schwartz argued that the Depression was caused less by a lack of demand than by a drop in the money supply. As Figure 14.1A shows, between 1929 and 1933, the amount of money in the economy dropped sharply as banks failed and wiped out the accounts of depositors. As the money supply shrank, people hoarded what dollars they had. Friedman and Schwartz called the result the “great contraction,” a period of falling prices, rising unemployment, and declining incomes.

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Figure 14.1A Milton Friedman argued that the Federal Reserve turned a recession into a depression by allowing the money supply to contract sharply between 1929 and 1932. The line graph shows changes in the money supply during Depression years. The bars show the rate of change in real gross domestic product (GDP). What relationship do you see between the two measures?

The cure, in their view, lay not in fiscal but in monetary policy. The Federal Reserve should have reacted to the crisis, the economists argued, by expanding the money supply. Later in this lesson, you will read how this expansion is done. With more money in circulation, spending would have picked up and the economy would have started to grow again. As Friedman would later write,

The Fed was largely responsible for converting what might have been a garden-variety recession, though perhaps a fairly severe one, into a major catastrophe. Instead of using its powers to offset the depression, it presided over a decline in the quantity of money by one-third from 1929 to 1933 . . . Far from the depression being a failure of the freeenterprise system, it was a tragic failure of government. —Milton and Rose Friedman, Two Lucky People , 1998

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Milton Friedman (left) is best known for his work on monetarism. He was also one of the early recipients of the Nobel Prize for Economics, shown here, a recognition of his many contributions to the field.

Friedman and Schwartz’s ideas about the importance of the money supply and monetary policy became the basis for the school of economic thought known as monetarism. According to monetarism, changes in the money supply play a primary role in the ups and downs of the economy. If the money supply grows too rapidly, inflation results. With more money in their pockets, consumers demand more goods and services than firms can supply, driving prices up. If the money supply grows too slowly, deflation results, and spending and investment slow. Therefore, the goal of monetary policy should be to increase the money supply just fast enough to keep up with economic growth—but no faster. Though Friedman and Schwartz have both died, their ideas have influenced a generation of economists. In a 2002 speech honoring the economist on his 90th birthday, Ben Bernanke, then a member of the Board of Governors of the Federal Reserve System, recognized Friedman and Schwartz’s many contributions to economics. Bernanke concluded with this pledge:

Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again. Level: A

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—Ben Bernanke, Nov. 8, 2002

Figure 14.1B The misery index is the unemployment rate added to the inflation rate. Economists studying this index have observed that crime rates tend to rise and fall along with the combined inflation and unemployment rates. As you can see, the index rose throughout the 1970s and peaked in 1980.

Using Monetary Policy to Fight Stagflation The use of monetary policy to stabilize the economy was put to the test in the late 1970s. Early in that decade, the economy received a shock when the 2020 Teachers' Curriculum Institute

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Organization of the Petroleum Exporting Countries (OPEC) imposed an oil embargo on the United States and other oil-importing countries. Supplies of oil dwindled, driving up the price of gas. The inflation rate, which had already reached worrisome levels, soared into double digits. As the economy struggled with rising prices, business activity slowed, and the unemployment rate climbed. The result was an unhappy economic situation known as stagflation. President Nixon tried to curb inflation by imposing temporary controls on wages and prices. As soon as the controls were lifted, however, prices shot up again. In 1974, President Gerald Ford launched an antiinflation crusade called Whip Inflation Now, or WIN, but inflation remained a problem. While running for president in 1976, Jimmy Carter scolded Ford for letting the “misery index” rise to more than 13 percent. The misery index is the sum of the inflation and unemployment rates. After taking office, Carter watched helplessly as the index climbed to more than 20 percent. In 1979, President Carter appointed Paul Volcker as chair of the Federal Reserve Board to bring inflation under control. Influenced by Friedman’s writings on monetary policy, Volcker set out to slow the growth of the money supply. The result of his slow-growth policy was a far faster reduction in the inflation rate than most economists thought possible. The inflation rate dropped from 13.6 percent in 1980 to 3.2 percent in 1983. This achievement was not without costs, however. During this same period, interest rates soared to historic highs. With the cost of borrowing so high, business activity plummeted and unemployment reached almost 11 percent—its highest rate since the Great Depression. The Focus of Fiscal and Monetary Policy Today Over the past halfcentury, mainstream economists have come to view both fiscal and monetary policy as useful in managing the economy. Since the end of World War II, both have been used with some success to, as economists put it, “tame the business cycle.” In an ideal world, policymakers using fiscal and monetary policy would keep the economy growing steadily and also keep inflation and unemployment low. However, in the real world, the economy still follows the ups and downs of the business cycle, but there is much that can be done to alleviate the worst effects.

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2. What Tools Does Fiscal Policy Use to Stabilize the conomy? Fiscal policy consists of decisions made by the government regarding how much money to spend and how much to collect in taxes. At the national level, Congress makes these decisions based on recommendations from the president. Fiscal policy is used to pursue a number of economic goals. These goals include low unemployment, stable prices, and economic growth. The tools that fiscal policymakers use to achieve those goals are aimed at expanding or contracting economic activity. How Taxes and Spending Expand or Contract the Economy Early in 2008, Congress enacted an economic stimulus bill in response to worries that the economy was sliding into a recession. More than 130 million households received stimulus checks that year. Payments in the form of a tax rebate—a return of tax money to taxpayers—began at $300 for a single person and rose from there, depending on the size of each family. President George W. Bush described the stimulus as “a booster shot for our economy.” Stimulus checks are just one tool the government can use as part of an expansionary fiscal policy . The goal of this policy is to promote economic activity by increasing government spending, cutting taxes, or both. These tools can be used to help businesses grow—for example, by increasing government spending on goods and services. Or they can be aimed at boosting consumer spending, which was the purpose of sending Americans stimulus checks. In contrast, the goal of a contractionary fiscal policy is to cool an overheated conomy. When buyers demand more goods and services than the economy can produce, overall prices tend to rise. When this happens, Congress can use the same tools to dampen excessive demand. That is, Congress can cut government spending, increase taxes, or both. As this demand drops, prices tend to stabilize.

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Using Tax Cuts to Stimulate Growth In the early 1980s, a debate arose ver how tax cuts might best be used to encourage economic growth. On one side of the debate were supporters of Keynesian economics. This school of thought is also known as demand-side economics. Demand-siders believe that the best way to deal with a sluggish economy is to stimulate overall demand by cutting individual income taxes. As consumers spend the money they save on taxes on goods and services, business will pick up and the economy will begin to grow. On the other side of the debate were advocates of a theory called supply-side economics. Supply-siders hold that the best way to deal with an economic slowdown is to stimulate overall supply. This can be done by cutting taxes on businesses and high-income taxpayers. As businesses and investors use their tax savings to expand production, the supply of goods and services will increase, spurring economic growth. Inspired by supply-side theories, President Ronald Reagan pushed for major tax cuts in 1981. In response, Congress lowered the corporate income tax rate at the highest bracket from 48 percent to 34 percent. Congress also slashed the top marginal income tax rate from 70 percent to 28 percent over the next seven years.

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Figure 14.2A The Laffer curve illustrates a theoretical relationship between marginal income tax rates and tax revenues collected by the government. As tax rates rise from a low of 0 percent, government revenues rise as well. However, at some point, revenues start to fall as tax rates discourage people from working harder to earn more income. The curve does not tell us, however, just where that turning point is.

Critics of the Reagan tax cuts argued that the cuts would starve the government of needed revenue. In response, supply-siders claimed that the tax cuts would actually increase, not reduce, tax revenues. They supported their claim with a U-shaped graph, known as the Laffer curve. Popularized by economist Arthur Laffer, the graph shows a theoretical relationship between tax rates and tax revenues. As shown in Figure 14.2A, the Laffer curve suggests that increasing taxes beyond a certain point may lower revenue. Likewise, cutting taxes at that point may increase revenues. The results of the Reagan tax cuts were mixed. Over the next few years, the economy grew, just as supply-siders had predicted. Tax revenues also increased, although less rapidly than people had hoped. 2020 Teachers' Curriculum Institute

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As a result, budget deficits grew and the federal debt ballooned, just as supply-side critics had feared. Today, economists generally accept that both demand-side nd supply-side approaches should be considered hen developing fiscal policy. How the Multiplier Effect Expands the mpact of Government Spending When the government spends money on goods and services, the impact on the economy is generally greater than the amount of money spent would suggest. The reason is that each dollar spent encourages still more spending, sending a ripple of economic activity through the economy. Economists call this rippling action the multiplier effect. To see how the multiplier effect works, look at what happens when a government decides to hire teenagers to build trails in a local park. Suppose one of those teenagers is paid $1,000 for a week’s work and decides to put 30 percent, or $300, in the bank. He spends the remaining $700 on a bicycle. That $700 now becomes part of the bike shop owner’s income. Now suppose the bike shop owner spends $500 of that income on car repairs. That $500 becomes income to the auto mechanic. The mechanic saves $100 and uses the other $400 to hire someone to paint his fence. And so it goes, with the original $1,000 spent by the government rippling through the economy from one person to the next. Each time the money changes hands, some of it is spent again, creating more overall demand. The multiplier effect works in two ways. It can help the economy grow when the government increases spending, or it can slow economic growth when the government cuts spending. Consider, for example, the impact of a cut in government spending on highways. Construction firms that depended on highway projects would lay off workers. The laid-off workers would cut back on spending. Local businesses would see their sales drop. In this way, a reduction in government spending sends ripples through the economy, reducing demand by some amount along the way. How Automatic Stabilizers Smooth Out the Business Cycle Congress increases or cuts highway spending as part of its discretionary spending budget. However, discretionary spending accounts for only about one-third of the federal budget. The other twothirds is devoted to mandatory spending. Mandatory spending includes transfer payments, such as Social Security benefits. These transfer payments, along with taxes, can act as automatic stabilizers. An Level: A

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automatic stabilizer helps counter the ups and downs of the business cycle without requiring policymakers to take any action. Automatic stabilizers work by increasing or decreasing overall demand. Suppose, for example, the economy enters a slowdown. As people spend less, demand for goods and services drops. Businesses respond by laying off workers or reducing their workers’ wages. As workers’ earnings decline, many of them slip into lower federal income tax brackets. In the lower brackets, their tax bills go down at a faster rate than their incomes. This “tax cut” softens the impact of their reduced wages. Workers spend the money they save in taxes on goods and services, keeping the slumping economy from getting even worse.

Transfer payments also help boost demand for products and services during a downturn. As workers are laid off, many become eligible for unemployment benefits. Applications for food stamps and welfare payments also increase. By putting money in people’s pockets, these payments encourage spending and keep demand from dropping as rapidly as it otherwise would. Just the opposite happens during upswings in the economy. As earnings rise, wage earners move into higher tax brackets. With a higher percentage of each additional dollar earned going to taxes, spending cannot rise as fast as wages. This slowing of consumer spending helps stabilize demand. In addition, as employment picks up, the number of people needing transfer payments drops. Government spending declines, just as it would have had Congress deliberately adopted a 2020 Teachers' Curriculum Institute

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contractionary fiscal policy. By themselves, these automatic stabilizers do not have the power to end economic expansions and contractions. But as Figure 14.2B suggests, they may help smooth out the highs and lows of the business cycle.

Figure 14.2B Taxes and government transfer payments rise and fall with the business cycle. Since the end of World War II, these automatic stabilizers, combined with discretionary fiscal actions, have worked to limit the ups and downs of the economy. You can see their effect on this graph, which shows the growth of the gross domestic product since 1900.

3. What Tools Does Monetary Policy Use to Stabilize the Economy? Monetary policy consists of decisions made by a central bank about the amount of money in circulation and interest rates. In the United States, the Federal Reserve makes such decisions. Earlier you read about the Federal Reserve’s role in overseeing the nation’s banking system. The Fed also uses its control of monetary policy to help the economy grow steadily with full employment and stable prices. However, unlike Congress, which controls fiscal policy, the Fed is not an elected body. It has the power to make decisions on its own without the approval of either Congress or the president.

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The Structure of the Federal Reserve System In creating a central bank, Congress gave the Federal Reserve enough power to act independently when it comes to monetary policy. At the same time, the Fed’s structure ensures that its decisions take into account the needs and interests of all parts of the country. A seven-member Board of Governors based in Washington, D.C., heads the Federal Reserve System. The rest of the country is divided into 12 Federal Reserve districts. One Federal Reserve Bank operates in each district. These regional Federal Reserve Banks oversee the activities of national and statechartered banks in their districts. Figure 14.3A shows the 12 districts and their Federal Reserve Banks.

Figure 14.3A The Federal Reserve System serves as this nation’s central bank. It is structured in a manner that ensures representation from different parts of the country on its Board of Governors and on the Federal Open Market Committee. Note the concentration of Federal Reserve districts and banks in the eastern half of the country. This pattern reflects the distribution of the population in 1913, the year the system was established. 2020 Teachers' Curriculum Institute

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Members of the Board of Governors are appointed by the president and confirmed by the Senate to 14-year terms of office. Once confirmed, a member is limited to one term. In making appointments, the president is directed by law to select a “fair representation of the financial, agricultural, industrial, and commercial interests . . . of the country.” To ensure geographic representation, each new appointed governor must come from a different Federal Reserve district. The president also selects one board member to chair the board for a fouryear term. Jerome Powell, who joined the Board of Governors in 2012, became its chairperson in 2018. The chairperson serves as the primary spokesperson for the Fed, both with Congress and with the public. The Board of Governors is responsible for the overall direction of monetary policy and for supervising the banking system. The board also publishes a wealth of statistics about the U.S. economy. In addition, all board members serve on the powerful Federal Open Market Committee (FOMC). The FOMC includes 5 of the 12 Federal Reserve Bank presidents as well. The president of the New York Federal Reserve Bank is always on the FOMC, in recognition of New York City’s status as the country’s financial center. The other Federal Reserve Bank presidents rotate to fill the four remaining slots. The FOMC holds eight regularly scheduled meetings each year to assess the state of the economy. At these meetings, the committee examines a wide range of economic indicators. From this information, it determines what changes, if any, the Fed should make in its monetary policy. As with fiscal policy, the decisions of the Fed may be expansionary or contractionary in their effects. Fighting Recession and Inflation with Monetary Policy The Fed adopts an expansionary monetary policy when it believes that the economy is in danger of sliding into a recession. Also known as an easy-money policy, an expansionary monetary policy is intended to speed the growth of the money supply. As the amount of money flowing into the economy increases, interest rates drop and borrowing becomes cheaper and easier. With loans easier to get, households and firms spend more on goods and services. Demand increases, leading to more production, stronger economic growth, and a drop in the jobless rate. On the other hand, the Fed pursues a contractionary monetary policy when rising prices threaten to trigger an inflationary wage-price spiral. Level: A

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Also known as a tight-money policy, a contractionary policy is intended to slow the growth of the money supply. With less money flowing into the economy, interest rates rise and loans become costlier and harder to get. Households and firms cut back on borrowing as well as spending. Demand shrinks, leading to less production, weaker economic growth, and a drop in the inflation rate. How Banks Create and Destroy Money To understand how the Fed regulates the money supply, we need to look at how banks create or destroy money. Banks are in the business of taking in money from depositors and using it to make loans. They make their profit from the interest they charge on those loans. However, because of the reserve requirement—the regulation that banks must keep a certain percentage of deposits on hand to repay depositors—banks cannot loan out all of the money that they take in. They must hold some cash in their vaults or on deposit in a Federal Reserve Bank as a reserve fund.

Because it is not readily available for use, money held in reserve by banks is not considered part of the M1 money supply. M1 is the most common measure of the amount of money circulating in an economy. It includes all bills and coins in use, as well as traveler’s checks and money in bank checking accounts. When you deposit money in a bank account, it goes into the bank’s reserves along with everyone else’s deposits. Your account is credited 2020 Teachers' Curriculum Institute

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with the amount of your deposit, which becomes part of the money supply. The bank can then loan the portion of your deposit that is not required to remain in reserve to someone else. The money loaned may be used to buy goods or services. Or, it may end up in the borrower’s checking account. Either way, that money is now also part of the M1 money supply. So, in this sense, the bank has “created” money by making a loan. The reverse happens when a borrower repays a bank loan. The money used to pay off the loan leaves the borrower’s checking account and goes back into the bank’s reserves. As the borrower’s checking account shrinks, the money supply also shrinks. In this sense, paying off a bank loan “destroys” money—at least until the bank loans that money to other borrowers. The Federal Reserve can speed or slow money creation by making it easier or harder for banks to make loans. Whether its goal is to increase or decrease the money supply, the Fed uses the same three tools: open-market operations, the reserve requirement, and the discount rate. Of these, open-market operations are the most important. The Fed’s Most-Used Tool: Open-Market Operations The Federal Reserve can inject money into the economy or pull it out using openmarket operations. An open market is a market that is open to all buyers and sellers. The Fed’s open-market operations involve the buying and selling of government securities in the bond market. The securities can be Treasury bonds, notes, bills, or other government bonds. The decision to expand or contract the money supply in this way is made by the FOMC. When the FOMC adopts an easy-money policy, it instructs the Fed’s bond traders to buy government securities. Every dollar the Fed pays for bonds increases the money supply. When the FOMC adopts a tight-money policy, its bond traders sell securities in the bond market. The public pays for these bonds with cash or money taken out of banks. As this money goes out of circulation, the money supply shrinks. Moreover, because banks end up with smaller deposits, they have less money to lend, which also slows the growth of the money supply.

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Figure 14.3B Banks create money by using the deposits in checking accounts to make loans. This illustration shows how the money-creation process works, starting with a gift of $1,000. • Notice that each time a bank receives a deposit, it keeps 10 percent in reserve and loans the rest. • Remember that the money supply includes both currency in circulation and deposits in checking accounts.

Open-market operations are relatively easy to carry out. They allow the Fed to make small adjustments in the money supply without new laws or banking regulations. For these reasons, the sale and purchase of securities is the monetary tool the Fed uses most to stabilize the economy. The Fed’s Least-Used Tool: The Reserve Requirement The Fed’s least-used monetary tool is its power to set the reserve requirement for banks. The Fed’s Board of Governors could expand or contract the money supply by adjusting the required reserve ratio. This ratio is the minimum percentage of deposits that banks must keep in reserves at all times. Lowering the ratio would allow banks to make more loans and create more money. Raising the reserve ratio would force banks to 2020 Teachers' Curriculum Institute

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keep more cash in reserve and out of the money supply. This, in turn, would leave banks with less money to lend, slowing the creation of money. In practice, changes in the required reserve ratio are infrequent—and for good reason. Think about what a change in the requirement might mean for banks. A lower percentage might not be a problem. Banks would be happy to have more money to lend. To meet a higher ratio, however, a bank would have to scramble for extra cash. It could borrow the needed money, but it would have to pay interest on the loans. Or the bank could refuse to renew loans as they come due. To avoid these negative impacts, the Fed seldom uses reserve requirements as a tool of monetary policy. For many years, the reserve requirement ratio has been 3 or 10 percent, depending on the amount of a bank’s deposits. The Fed’s Third Tool: The Discount Rate Even when the reserve requirement remains stable, banks sometimes need to borrow money to keep their reserves at the proper level. This might happen because a bank has made too many loans, or it could be a result of unexpectedly large withdrawals. Whatever the reason, banks can borrow money from a Federal Reserve Bank to shore up their reserves. The interest rate on such loans, known as the discount rate, is the last tool in the Fed’s toolbox.

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The speaker in this cartoon believes that the Federal Reserve should have used its monetary policy tools to keep inflation in check by implementing a tight-money policy. The fact that the hot dog vendor is charging $25 for a hot dog is a clear sign that inflation is out of control.

The Federal Reserve Board of Governors controls the discount rate. A low rate makes it less costly for banks to borrow from the Fed. Banks can then use that money to make loans to customers, thereby expanding the money supply. Raising the discount rate has the opposite effect by discouraging banks from borrowing from the Federal Reserve. With money tight, banks make fewer loans, which keeps the money supply in check. Unlike the reserve requirement, the discount rate changes frequently over time. Between 1990 and 2018, it ranged from a high of 7.0 percent to a low of less than 0.1 percent. Whatever the rate, banks usually view the Federal Reserve as a lender of last resort. Borrowing from the Fed, they worry, may send a signal that the bank is in trouble. Instead, banks generally borrow the funds they need from other banks. Knowing this, the Fed does not use the discount rate as its principal tool for managing interest rates. Instead, it targets the rate that banks 2020 Teachers' Curriculum Institute

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charge one another for loans. Targeting the Federal Funds Rate When the Fed makes news, the story is almost never about changes in the money supply or the discount rate. Instead, the report is usually about a change in the federal funds rate. This is the rate that banks charge one another for very short—as short as overnight—loans. Such lending is common between banks with excess reserves and banks that need a quick loan to maintain their required reserves. Unlike the discount rate, the federal funds rate is not a monetary policy tool. Banks, not the Fed, decide what they charge one another for loans. Still, the Fed has an interest in making sure that the rate banks are charging one another is in line with its general monetary policy. Therefore, the FOMC sets a target for the federal funds rate based on its view of the economy. It then uses open-market operations to nudge the federal funds rate toward that target. The FOMC focuses on the federal funds rate for two main reasons. First, it is the easiest bank rate for the Fed to change using open-market operations. Second, interest rates on everything from saving accounts and bonds to mortgages and credit cards are affected by the federal funds rate. Thus, a small change in the federal funds rate can have a powerful effect across the entire economy. As with all of its activities, the Fed has two goals in mind when targeting the federal funds rate. One is to control inflation, as you can see in Figure 14.3C. The other is to maintain healthy economic growth. Getting the rate right to do both is a challenging task, especially because it can take months for a change to work its way through the economy.

4. What Factors Limit the Effectiveness of Fiscal and Monetary Policy? Despite the best efforts of policymakers, booms and busts still happen. One reason may be that the business cycle is simply a fact of life in a market-based economy, but other factors may also keep fiscal and monetary policy from being as effective as economists would like. Time Lags Can Complicate Policymaking Level: A

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time lags plague economic policymaking. One lag comes from the time it takes to compile accurate economic data. Early estimates of GDP growth, for example, are often too high or too low. As a result, economists may miss the start of a recession. Only when the indicator is corrected months later does the actual state of the economy become clear. By then, corrective action may be too late to do much good. Another time lag comes from the time it takes for actions begun today to work their way through the economy. The multiplier effect of federal spending can take months to stimulate or dampen overall demand. After studying efforts to use fiscal policy to combat recessions since World War II, historian Bruce Bartlett concluded,

The history of anti-recession efforts is that they are almost always initiated too late to do any good . . . The enactment of stimulus plans is a fairly accurate indicator that we have hit the bottom of the business cycle, meaning the economy will improve even if the government does nothing. —Bruce Bartlett, “Maybe Too Little, Always Too Late,” New York Times, Jan. 2008 In general, monetary policy can be enacted more quickly than fiscal policy. Even so, a change in interest rates may take six months or more to have an effect on economic output or the inflation rate.

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Economic Forecasts Can Mislead Policymakers To implement economic policy successfully, policymakers must be able to forecast how the economy will behave months or even years into the future. To make such forecasts, economists monitor several economic indicators. They also use economic models and computer programs to make sense of the data. Based on their models, they make educated guesses about the future. Policymakers use these forecasts to decide what actions to take to head off recessions or fight inflation. Predicting the future is never easy, and sometimes forecasters guess wrong. An example of a prediction that did not come true occurred in 2001. As the first graph in Figure 14.4A shows, the federal government began that year with a budget surplus. The Congressional Budget Office responded with a report forecasting continued surpluses through 2011. The CBO also predicted that by 2009, the accumulated surplus would be large enough to pay off the national debt. The second graph in Figure 14.4A shows just how wrong these forecasts turned out to be.

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Figure 14.4A The federal budget is in deficit when spending exceeds tax revenue. It is in surplus when revenue exceeds spending. Every budget deficit adds to the national debt, just as every surplus subtracts from the debt. Since 1975, budget deficits have been the rule, not the exception. As a result, the national debt reached almost $22 trillion by the end of 2018.

Concerns About the National Debt May Limit Government Spending Worries about the size of the national debt may also complicate policymaking. When Keynes urged President Roosevelt to increase deficit spending, he did not mean that the federal government should run deficits forever. The result, Keynes realized, would be an ever-increasing national debt. Such a debt would not be in the longterm interests of the economy. Instead, most economists advise that deficit spending be limited to times of national emergencies. Such emergencies include wars, natural disasters, and recessions. During good economic times, they say, Congress could run surpluses. These surpluses could then be used to 2020 Teachers' Curriculum Institute

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pay down the national debt, balancing the federal budget over time. That is the theory. Since the 1970s, however, the federal government has generally spent more than it receives in revenue in both good times and bad. The inability of Congress to keep spending under control has led some politicians to call for a constitutional amendment requiring a balanced budget. The Senate approved an early version of such an amendment in 1982. The House approved a later version in 1997. Meanwhile, deficit spending continued. By December 2018, the national debt had climbed to about $22 trillion. Each individual’s share of that debt amounted to almost $70,000. The size of the national debt has many Americans deeply worried. Listed below are some of their concerns.

Fear of government bankruptcy. Some people worry the national debt will eventually bankrupt the federal government. Most economists, however, doubt that will happen. As long as the government can increase taxes or refinance the debt, it will not go into bankruptcy. To refinance the debt, the government sells new bonds and then uses that money to repay bondholders whose bonds have matured. Concern about the burden on future generations. Many people are concerned about the burden that a large national debt will place on the next generation— namely, you and your friends. Once again, however, many economists believe this worry is overblown. As shown in Figure 14.4B, about two-thirds of the national debt is owned by American individuals or institutions. Economists look at this portion of the debt as money we owe ourselves.

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Figure 14.4B Economists often describe a portion of the national debt as money we owe ourselves. As this graph shows, however, about one-third of the debt is owned by other countries. Some Americans view foreign ownership of U.S. government securities as a sign of confidence in the strength of the U.S. economy. Others worry that the federal government has become too dependent on foreign lenders.

Taxpayers do bear the burden of paying interest on that debt, but much of that money goes right back to Americans who own government securities. Many retired people, for example, depend on the interest from government bonds to support themselves. They have no wish to ask any generation, including yours, to “pay off” the national debt.

Unease about foreign-owned debt. Citizens, government agencies, and financial institutions in foreign countries own about one-third of the national debt. This is not debt that we owe to ourselves. Foreign ownership of so much of the national debt concerns Americans for two reasons. First, they do not like seeing all of the interest owed to foreign bondholders flowing out of the U.S. economy. Second, they worry that Congress is becoming too dependent on foreign lenders to support its deficit-spending habits. What will happen, they ask, if people from other countries suddenly decide that they no longer want to buy U.S. government securities? Many economists share these concerns to some degree. However, they 2020 Teachers' Curriculum Institute

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point out that payments to foreign bondholders enable those bondholders to buy U.S. goods and services. Economists also note that many Americans invest in bonds issued by foreign governments. The interest these bondholders receive helps offset U.S. payments to foreigners. Finally, as long as our economy is strong, foreigners are unlikely to stop buying U.S. government securities.

Worries about the crowding-out effect. A widespread concern about the growth of the national debt is that the federal government is crowding private borrowers out of the lending market. This crowdingout effect is said to happen when government borrowing drives interest rates up so high that people are no longer willing to borrow money to invest in businesses. This could trigger an economic downturn. Economists agree that crowding out is a potential problem. However, they note that the negative effect of the government’s borrowing on long-term growth depends on how the money is spent. Government spending on highways and airports benefits private enterprise. So does spending on education and research, which improves this country’s human capital. Do all of these limitations and concerns mean the economy would be better off if policymakers did nothing to stabilize it? Some critics of fiscal and monetary policy would answer yes, but mainstream economists say both fiscal and monetary policy play an important role in keeping the economy healthy. In your lifetime, you are likely to live through both recessions and periods of high inflation. Either situation can create hardships that you would rather not face. Still, knowing that the government has tools to help the economy recover from such ills may help you face them with confidence. For having learned how these tools work, you now know that the bad economic times will not last forever.

Summary Governments and central banks use two broad policies to keep their economies running smoothly. Fiscal policy is based on the government’s power to tax and spend. Monetary policy is based on the power of the Federal Reserve over the money supply and interest rates. What are the origins of modern fiscal and monetary policy? British economist John Maynard Keynes championed the use of fiscal Level: A

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policy to fight recessions. Keynesian economics holds that government spending should be used to stimulate demand during recessions. American economist Milton Friedman promoted the use of monetary policy to control inflation. Monetarism holds that the control of the money supply is key to keeping inflation in check. What tools does fiscal policy use to stabilize the economy? Expansionary fiscal policy tools include increased government spending and tax cuts. Contractionary fiscal policy tools include decreased government spending and tax increases. Automatic stabilizers can also serve to expand or contract the economy. What tools does monetary policy use to stabilize the economy? The Federal Reserve works to stabilize the economy by managing the growth of the money supply and interest rates. Its tools include the power to establish bank reserve requirements and the discount rate. Through its open-market operations, it also regulates the federal funds rate. What factors limit the effectiveness of fiscal and monetary policy? A number of factors keep fiscal and monetary policy from maintaining a stable course for the economy. These factors include lack of timely information, inaccurate forecasts, and time lags between actions and their effects.

Interest Rates: Short-Term Versus Long-Term This essay examines the difference between short-term and long-term interest rates. It discusses how the different rates are set and explains their relative significance.

The Difference Between Short-Term and Long-Term Rates An interest rate is the price a borrower must pay for a loan. It is calculated as a percentage of the amount borrowed. The term of the loan is the period for which the money is borrowed. A short-term interest rate is paid on a loan of one year or less. A long-term interest rate is paid on a loan of ten years or more. Any period between one year and ten years is known as intermediate term. This description also applies to the interest paid on such investments as debt securities, or 2020 Teachers' Curriculum Institute

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bonds, which are essentially loans made to governments or businesses. Short-term rates are charged on most consumer loans, including credit card debt, car loans, home-equity loans, and adjustable-rate mortgages. Investments that typically pay short-term interest include Treasury bills, money market funds, and bank certificates of deposit. Long-term rates are generally charged on fixed-rate home mortgages of 15 or 30 years. Investments that pay long-term rates include Treasury bonds of ten years or more.

How Rates Are Set Both short-term and long-term interest rates reflect such economic factors as inflation and the pace of economic growth. The Federal Reserve, or Fed, has great control over short-term rates, however, and much less influence over long-term rates. The Fed's control over short-term rates is one of its main monetary policy tools. If the Fed determines that the economy is heating up and inflation is too high, it can raise the federal funds rate, or overnight rate. This is the rate that banks charge each other for short-term loans. By raising the federal funds rate, the Fed discourages lending and slows down the economy, thus tamping down inflation. If the Fed sees that the economy is growing too slowly, it can lower the federal funds rate and encourage more lending and borrowing, thus stimulating the economy. When the Fed raises the short-term rate, consumer loans based on this rate become more expensive. When it lowers the rate, those loans become cheaper. So, for example, a lower rate means that consumers with credit card debt will begin to see their interest rate and payments come down. The Fed has no direct control over long-term rates. Those rates depend much more on market conditions and the general level of confidence in the economy. If investors believe they can look forward to an extended period of low inflation, long-term rates are likely to remain low. If, on the other hand, there is general concern about rising inflation over the long term, long-term interest rates will tend to rise. The Fed's actions can influence long-term rates by bolstering investor confidence, but the effects are indirect and less predictable.

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Spending Priorities: Rebuilding the Nation’s Infrastructure This essay considers the value of investing in projects to rebuild the nation's infrastructure. It examines the role of infrastructure in the national economy. It also looks at the debate over infrastructure investment as a fiscal stimulus.

The Role of Infrastructure in the Economy A well-developed infrastructure is critical to the national economy. Infrastructure includes all the manufactured physical assets on which a nation depends: bridges and highways, ports and airports, power stations and electrical grids, water and sewage systems, communications networks, schools, and mass-transit systems. A reliable infrastructure is one of the things that distinguish richer, developed countries from poorer, developing nations. It is one of the foundations of a strong economy. The United States has a well-established infrastructure that has evolved over many years. Much of it was built during the decades following World War II, when the economy was expanding rapidly. But the elements of an infrastructure do not last forever. Roads and bridges fall apart. Power and water systems become outdated and no longer meet the needs of a growing population. Communications networks, schools, and transit systems become outmoded and require renovation. For all these reasons, rebuilding infrastructure is one of the federal government's spending priorities. Infrastructure projects are expensive, however, and in any given year they may seem less urgent than other budgetary needs. As a result, infrastructure development often takes a back seat to other priorities.

Infrastructure Investment as a Fiscal Stimulus In times of economic crisis, infrastructure projects may have added appeal as a fiscal stimulus to boost the economy. This was the case during the Great Depression, when the government invested in public projects to generate jobs and get people back to work. This approach, based on Keynesian economics, assumed that public investment would stimulate demand for goods and services and get the economy moving again. 2020 Teachers' Curriculum Institute

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A similar scenario arose more recently, in 2008, when a collapse of financial markets triggered a severe recession. This economic crisis prompted calls for emergency action and resulted in a major economic stimulus package, passed by Congress in early 2009. This fiscal package included tax cuts and spending increases designed to stimulate economic growth. Among the spending measures were investments to rebuild the nation's infrastructure. Many economists at the time argued that infrastructure investment was essential for economic recovery. Nobel Prize–winning economist Paul Krugman wrote in The New York Times, “Fiscal expansion will be even better for America's future if a large part of the expansion takes the form of public investment—of building roads, repairing bridges and developing new technologies, all of which make the nation richer in the long run. Other economists warned, however, that infrastructure projects often take years to get off the ground. Much of the money allocated by Congress would not be spent for many months, perhaps even after the recovery had already begun. For that reason, they said, infrastructure investment may not be an effective fiscal stimulus, even if it is good for the economy in the long run. Some conservative economists were even more critical, arguing that the best way to promote economic recovery is to cut taxes, not to invest in infrastructure. In the end, the debate over the stimulus package resulted in a bill that contained $150 billion in infrastructure spending, less than many economists had recommended. The plan included money for transportation and energy projects, clean water facilities, public housing, scientific research, and expanded Internet service, among other public investments.

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Growing the Economy Economic Question: What can the government do to strengthen the economy?

Inquiry Introduction In this unit, you examined how economists assess the health of the economy and the ways that government can affect it. Now, you will apply what you have learned in this Economic Inquiry. You will investigate the Economic Question by identifying economic indicators and creating related policies that the government can implement to strengthen the economy.

Storyline Suppose you are a researcher at a think tank that is known for its expertise on economic issues. Every year, it produces an influential report that examines the state of the economy and suggests government policy to ensure that the economy is on a positive course. Government officials and legislators often look to the report for guidance in creating policies and programs. As a researcher, you have been asked to work with your team to develop a policy and an implementation plan for a specific economic indicator. Your team will conduct research to assess the state of the economy, establish a target goal for your assigned economic indicator, and suggest policy initiatives. You will then present your findings to the entire research team, including management.

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During the Great Recession, from December 2007 to June 2009, real GDP reached its low point, -8.4 percent, in the fourth quarter of 2008 and recovered in 2009. In contrast, unemployment peaked at 10 percent in October 2009 after the recession had ended and remained high for a period of several years.

Background Economists assess the state of the economy based on various economic indicators, including gross domestic product (GDP) and the unemployment rate. However, these indicators do not react in unison to changes in the economy. Shifts occur with different parts of the business cycle. For example, GDP rises or falls as the economy expands or contracts; it is a coincident indicator, or a metric that shows the current state of the economy. In contrast, as a lagging indicator, the unemployment rate changes several months after an expansion or contraction has begun and helps economists confirm when phases of the business cycle end and begin. Changes in economic indicators were evident during the economic downturn, known as the Great Recession, that began in December 2007 and continued until June 2009. In the first quarter of the recession, real GDP declined from 2.5 percent to -2.3 percent. However, the unemployment rate remained steady from December 2007 to April 2008, when it then began to climb. In fact, the unemployment did not peak until October 2009—after the recession had ended.

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In this activity, you will work with a team of researchers to assess the state of the economy and present a policy proposal. By going through the inquiry process, you can investigate how the government can strengthen the economy.

Inquiry Process As you consider the Economic Question, you may wonder how to determine what steps the government can take to strengthen the economy. To conduct an inquiry, you can follow these steps and record your findings in your Interactive Student Notebook: In teams of four, write a hypothesis about the present state of the economy. Research six economic indicators—GDP, the unemployment rate, the federal deficit, the national debt, the consumer price index, and the producer price index—to determine the state of the economy. As you conduct research, evaluate your sources. Make 2020 Teachers' Curriculum Institute

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sure that you use reliable sources. Describe the state of the economy and indicate whether your hypothesis is correct. Explain the similarities and differences between your hypothesis and the actual state of the economy. Use evidence from your research and reasoning to support your answer. Determine what the government’s goal should be for your assigned indicator to help strengthen the economy over the next year. Conduct research to identify fiscal and/or monetary policies that could be implemented to support your goal. Evaluate your sources and make sure that they are reliable. in order to reach the goal for your indicators. Use evidence from your research and reasoning to support your plan. Present your proposal to the class. Be ready to answer questions from the class about your policy suggestions. By following these steps, you will become more informed about steps that the government can take to strengthen the economy. You will better understand the role of government in supporting the economy. When you are ready, work with your research team and begin investigating the Economic Question.

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The United States and the Global Economy How do countries conduct trade in the global economy?

Vocabulary Glossary Vocabulary Cards global economy imports exports free trade protectionism protective tariff foreign exchange balance of trade

Introduction

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Trade among countries plays an important role in shaping the U.S. economy.

In 1971, Marc McCreary and his family opened a T-shirt factory in Florence, Alabama. Within a few years, his business was booming, with more than 1,000 employees and millions of dollars in sales. Other Tshirt factories also opened in Florence, as people hoped to cash in on the growing market. Florence began calling itself the “T-Shirt Capital of the United States.” But then the boom went bust. In the early 2000s, imported T-shirts from China and other low-wage countries began flooding the U.S. market. These shirts were comparable in quality to American shirts, but much cheaper. Florence’s factory owners tried to boost productivity and lower costs, but in the end, they could not compete. “You can’t fix this by working harder,” McCreary later told a reporter for National Public Radio. “This is a global situation. None of us could figure this out.” In 2003, McCreary had to close his factory and lay off his workers. The other T-shirt firms in Florence also shut down. Thousands of people lost their jobs, and the economy of Florence suffered a major blow.

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For a few years the city struggled with the effects of the plant closings. Then, it began to recover. Some laid-off workers enrolled in retraining programs to learn new skills. Others opened their own small businesses. Outside firms, including some foreign companies, relocated to Florence to take advantage of the area’s skilled workforce. Although some laid-off workers had trouble getting back on their feet, others moved on to new and even better jobs. The story of Florence and the T-shirt industry reflects changes in the American economy as it becomes increasingly tied to the global economy. The global economy is the system of markets and trade that links the countries of the world. Economists generally agree that, despite the challenges of foreign competition, the benefits of participating in the global economy far outweigh the costs. This lesson focuses on one of the most important aspects of the global economy— global trade—and its role in shaping the U.S. economy. It also looks at the financial system that makes trade across borders possible.

1. Why Is Global Trade Growing in Importance? Take a look at the label on your shirt. Does it say “Made in U.S.A.”? Chances are that it does not. Although Americans can still buy clothing made in U.S. factories, most of the apparel sold in this country is produced in other countries. The same is true for electronic goods and many other products. The abundance of foreign-made goods in American markets underscores the increasing importance of global trade. The Growth of Global Trade As Figure 15.1 shows, international trade has grown dramatically since the end of World War II. Over the past half-century, the worldwide trade in merchandise, which includes all types of goods, has expanded 150 times, or by 15,000 percent. A number of developments have combined to make this increase in global trade possible. First, advances in transportation have had a major impact on crossborder trade. It is easier to move goods around the world than ever before. Ships are much larger today than they were 50 years ago, enabling them to carry more goods at a lower cost per unit. Container ports have facilitated shipping by allowing the loading and unloading of whole containers of goods. The development of wide-body, longdistance jet planes has made air transport cheaper and faster. As a 2020 Teachers' Curriculum Institute

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result, perishable goods such as fresh fruits and vegetables can be shipped thousands of miles without spoiling. Improved communications have also fueled the growth of global trade. Satellite systems now link computers and telephones around the world, making it possible to communicate almost instantly across great distances. A company in one country can serve its customers in another almost as easily as if they were in the same city. Global business can be transacted, and money can be exchanged, with just a few keystrokes. A shift in the types of goods being produced and traded has further promoted global commerce. At one time, much of the trade between countries was in bulk commodities, such as grains, coal, and steel. These items were heavy and relatively hard to ship. Today, a large share of global trade is in lighter manufactured goods, such as computers and other electronic devices, which are easier to transport and which sell for much higher prices.

At your local grocery store, you most likely have seen bananas for sale. But because they require a tropical climate, these bananas must be imported from countries in Latin America or the Caribbean. Improvements in transportation have made this possible.

Why Countries Trade: Absolute and Comparative Advantage Countries trade with one another for the same reason individuals do: to get the goods and services they value at the lowest cost. Most countries lack either sufficient resources or large enough markets to produce Level: A

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everything their people would like to consume for themselves. A country like the United States, however, is rich enough and big enough to produce virtually everything it needs. Nonetheless, the United States and other large, wealthy countries still engage in trade with other countries. Why? Because even rich countries benefit when they specialize in the production of some goods and services and trade those products for other goods and services. Decisions about what to specialize in reflect a country’s absolute and comparative advantages. As you read earlier, a country has an absolute advantage in trade if it can produce something more efficiently than other countries can. Such an advantage might come from a country having access to a scarce resource or having the ability to produce something more cheaply than other countries can. For example, South Africa’s rich diamond deposits give it an absolute advantage in diamond production. A country has a comparative advantage in trade when it can produce a good or service at a lower opportunity cost than its competitors can. For example, the United States and Canada are both capable of producing jet airplanes and wood products. But the opportunity cost of producing timber is lower for Canada than it is for the United States, and the opportunity cost of producing jet airplanes is lower for the United States than it is for Canada. So, it makes sense for the United States to trade its relatively cheaper airplanes for Canada’s relatively cheaper timber. By specializing, both countries get the goods they want at a lower cost than if they tried to produce both goods for themselves.

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Figure 15.1 Global trade has increased sharply since the 1960s. • The first graph shows the rising value of merchandise exports—the overseas trade in goods—around the world between 1960 and 2017. • The second graph shows that over that same time span, the share of total global trade generated by the United States has decreased.

One country’s comparative advantage over another might stem from any of several differences between them. Three of the most important are differences in climate, factors of production, and technology.

Differences in climate. Many countries have a comparative advantage in the production of certain crops based on climate. Tropical countries export warm-weather crops like mangoes, bananas, and coffee. Countries with temperate climates trade grains like wheat and corn. Seasonal variations between the Northern and Southern hemispheres can also play a part. For example, during the winter months the United States and Europe buy fruits and vegetables from southern countries such as New Zealand and Chile, which are then in their summer growing season. Level: A

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Differences in factors of production. Countries with an abundance of a particular factor of production—land, labor, or capital—may have a comparative advantage in the production of goods derived from that resource. Canada, for example, with its extensive forestland, has a comparative advantage in timber products. China, with its huge population, has an advantage in the production of goods like clothing that require large amounts of low-cost labor. Japan, with its high national savings rate, is able to specialize in industries that require a lot of investment capital, like automobile manufacturing. Differences in technology. Countries that have developed high levels of technology also enjoy a comparative advantage in producing high-value goods. Japan’s advantage in auto production is in large part a result of advances in engineering and production methods. Similar advances in the software and pharmaceutical industries have given the United States and Europe a comparative advantage in those fields.

South Africa, with its abundant diamond deposits, has long enjoyed an absolute advantage in diamond production. In recent years, however, scientists have managed to grow gemquality synthetic diamonds using machines like the one shown on the bottom. Experts say these lab-grown diamonds are comparable to natural stones and could impact the diamond market.

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Differentiated Products Promote Global Trade Global trade is not solely a matter of absolute or comparative advantage. After all, many countries are equally efficient at producing all kinds of goods— cars, foods, movies, clothing. They do not have a particular advantage in the production of such goods, and yet they trade them nonetheless. The reason is simple. Consumers enjoy the variety created by differentiated products. Differentiated products are products that are essentially the same but are distinguished from one another by variations in style, materials, or taste. Consider a commonplace food like cheese. All cheese is basically the same—a product made of cultured milk. Looked at that way, one type of cheese is pretty much the same as another. But consumers who buy cheese do not look at it that way. Cheese is a differentiated product. The unique tastes and textures of the many varieties are strong selling points for consumers. Shoppers tend to seek out specific cheeses— French brie, Greek feta, Italian parmesan—to suit their particular tastes and menus. This demand drives the international trade in cheeses. The same principle applies to other products and countries. Consumers may seek out leather shoes and handbags from Italy, popular music from Great Britain, or animated movies from Japan. Economists note that differentiated products like these are an increasingly important factor in global trade.

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2. What Goods and Services Do Countries Trade? In 2005, Sara Bongiorni and her family carried out an unusual experiment. They tried to live the entire year without buying any products made in China. Bongiorni chronicled the experience in her book, A Year Without “Made in China”: One Family’s True Life Adventure in the Global Economy. The author discovered that Chinese goods are everywhere in the American marketplace. Anything from clothing, toys, luggage, furniture, and computers are made in China. Even American flags are made in China. Bongiorni came away from that year with a deeper understanding of U.S. ties to the global economy. The United States not only imports products from abroad. It also exports goods and services to other countries. Imports are products made in another country and sold domestically. Exports are products made domestically and sold in another country. In the global trading system, one country’s exports become another country’s imports, and vice versa. Countries all over the world are economically interconnected through trade.

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The United States as a Major Importer As Sara Bongiorni found out in her year without buying anything from China, the United States is the world’s leading importer of goods and services. In 2017, it imported about $568 billion worth of goods more than China, the second largest importer.

The first graph in Figure 15.2A shows the kinds of goods and services the United States imported in 2017 by category. The largest category that year was capital goods. Included in this group are goods that are used in the production of other goods and services. This category includes machines, computers, measuring instruments, and telecommunications equipment. Consumer goods other than automobiles ranked second. This category includes all types of products for personal and home use, ranging from household appliances, televisions, and furniture to clothing, jewelry, and cosmetics. The third largest category of imports in 2017 was industrial supplies. This category includes chemicals, minerals, wood products, cotton, petroleum products, and other fuels. Within this category, far more money was spent on imported crude oil than on any other good. The United States as a Major Exporter The United States is also one of the world’s top three exporting countries, along with the European Union and China. Its exports range from farm products, minerals, and manufactured goods to financial and transportation services. The second graph in Figure 15.2A shows the kinds of products U.S. producers export by category. Capital goods make up a large portion of U.S. exports. Among the most Level: A

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valuable exports in this category are industrial machines, civilian aircraft, civilian aircraft engines, and telecommunications equipment. The United States has a comparative advantage in exporting such hightech goods because of its high levels of human capital. At first glance, it might seem odd that the United States both imports and exports the same types of goods, such as automobiles and telecommunications equipment. The explanation for this paradox lies in product differentiation. German cars and American cars, though similar, are not the same. There is a market for German cars in the United States and a market for American cars in other countries. In the case of telecommunications equipment, the products differ more substantially. The United States imports cell phones and exports satellite communications equipment. The United States does not have a comparative advantage in cell phone production, but it does have an advantage in satellite technology. Therefore, it makes sense for the United States to export satellite devices and import cell phones. The Growth of Service Exports Services also make up a significant share of U.S. exports. In 2017, services accounted for more than onethird of all exports. As with manufactured goods, service exports reflect the country’s comparative advantage in fields requiring a highly trained workforce. Such fields include engineering, education, and information services. You might be wondering how a service, which is not a physical object, can be exported. Every time an American company sells a service to a foreign customer, whether in the United States or abroad, it is exporting that service. For example, when a foreign student pays to attend college in the United States, that education is considered a service export. Likewise, when a foreign traveler pays for a hotel stay in a U.S. city, that payment is classified as a service export. American banks, airlines, insurance companies, and shipping agencies all add to U.S. export totals when they do business with foreign clients. So, too, do entertainment companies when they sell American movies or musical recordings to customers overseas. America’s Trading Partners The United States trades with most countries in the world. However, it conducts more than half of its foreign trade with just ten countries. China is currently America’s chief trading partner. In 2017, trade with China represented more than 16 percent of total U.S. foreign trade.

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Canada is the United States’ second most important trade partner. The long border between the United States and Canada and the traditionally good relations between the two countries have contributed to the continued strength of U.S.-Canadian trade relations. In 2017, Canada accounted for about 15 percent of U.S. foreign trade.

After the signing of the North American Free Trade Agreement (NAFTA) in 1994, Mexico became another important partner in trade. Although there has been consideration to replace NAFTA with another trade agreement, the economic relationship between the two countries should remain strong. In 2017, Mexico accounted for more than 14 percent of U.S. foreign trade. Around half of U.S. trade is with wealthy, industrialized countries such as Germany and Japan. The other half is with newly industrialized countries such as China and Brazil. The Benefits of Global Trade for U.S. Consumers Trade with other countries has many benefits for U.S. consumers. Global trade gives us access to an enormous variety of goods and services. We also enjoy low prices for many goods because we import these goods from low-cost producers. This makes us better off. As economics writer Charles Wheelan points out, “Cheaper goods have the same impact on Level: A

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our lives as higher incomes. We can afford to buy more.” As a result, our standard of living improves. Global trade also increases competition among producers. This may cause some producers to go out of business, as it did the T-shirt makers of Florence, Alabama. At the same time, it creates new opportunities for innovative or lowcost producers to enter the marketplace. Moreover, the producers that survive become more efficient and productive, thus contributing to a healthier economy. For example, competition from Japanese and European automakers gives U.S. carmakers a strong incentive to make better vehicles at a lower cost. The resulting improvements benefit anyone who buys an American car.

Figure 15.2B The United States conducts most of its foreign trade with just ten countries. This graph shows the percentage of total U.S. foreign trade carried out with each of those key trade partners.

Finally, global trade enhances the flow of ideas around the world. The movement of products and services among countries opens societies to new ways of doing things. This exchange of new ideas and technologies 2020 Teachers' Curriculum Institute

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promotes further innovation.

U.S. carmakers respond to global competition by producing vehicles more efficiently, which may mean doing some of their manufacturing in other countries, or offshoring. This Ford manufacturing plant located in Germany is an example of this economic phenomenon.

The Impact of Global Trade on U.S. Workers As the story of the Florence, Alabama, T-shirt boom and bust makes clear, global trade can also have negative effects on American workers, at least in the short term. Workers who are employed in industries that fail in the face of foreign competition may lose their livelihoods as a result of global trade. In most cases, laid-off workers find new jobs, but some never manage to recover their former standard of living. This results in real hardship for people and communities. While some workers may have suffered as a result of global competition, the labor force as a whole has not. In 1971, when Marc McCreary opened his Florence T-shirt factory, the U.S. labor force participation rate was 60 percent. By 2003, the year his factory closed because of cheap imports, the percentage of adults in the labor force had risen to 66 percent. In the long run, global trade increases economic activity, which in turn, promotes economic growth. Workers who lose their jobs but retrain themselves for new careers generally improve their circumstances. As in any market, competition among buyers and sellers produces winners Level: A

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and losers. But for countries that use their resources wisely and exploit their comparative advantages, the gains created by global trade outweigh the losses.

3. How and Why Do Countries Regulate Trade? Have you ever tried to mail a package to another country at the post office? If so, you probably had to fill out a customs declaration. It asked you to list the items you were sending and to indicate whether they were gifts or goods to be sold. This information is required by customs—the government department responsible for examining goods entering a country and enforcing any trade restrictions on them. Economists have long argued against trade restrictions. Nonetheless, few countries have ever fully embraced free trade—the unrestricted movement of goods and services across borders. Over the years, countries have found many reasons to regulate foreign trade. Types of Trade Barriers: Tariffs, Quotas, Embargoes, and Voluntary Restraints Many countries restrict imports in order to shield domestic markets from foreign competition. Such behavior is known as protectionism. Countries do this mainly to satisfy political demands at home. There are many types of trade barriers. The four main types are protective tariffs, import quotas, trade embargoes, and voluntary export restraints.

Protective tariffs. The most common type of trade barrier is the protective tariff—a tax on imported goods. Countries use tariffs to raise revenue and to protect domestic industries from competition from cheaper foreign goods. Tariffs are among the easiest taxes to impose, since they arouse little domestic protest and can be easily applied to goods before they enter the country. While protective tariffs may help specific domestic producers, they do not benefit consumers. Tariffs push up the prices of imported goods. So, instead of having to lower prices to compete with cheap imports, domestic producers can raise prices to the inflated price level of the imports. Thus, tariffs make all goods more expensive for consumers. High protective tariffs can also have negative effects on the entire economy. The Hawley-Smoot Tariff Act, passed by Congress in 1930, raised the average tariff rate on imported goods to almost 60 percent. 2020 Teachers' Curriculum Institute

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Although 1,028 economists petitioned President Herbert Hoover to veto the bill, he signed it into law. In response, other countries raised their tariff rates. Foreign trade came to a halt, helping to turn a recession into a worldwide depression. Despite these drawbacks, most governments are still persuaded that tariffs are needed to protect their country’s workers and industries. In 2018, for example, the United States charged a 4.7 percent tariff on imported pianos, a 6.8 percent tariff on cut roses, and a 3.7 percent tariff on X-ray plates and film.

Import quotas. While tariffs make foreign goods more expensive, they do not limit the quantity of goods that can be imported. An import quota, on the other hand, places a limit on the quantity of a good that can be imported during a specified period of time. For example, an import quota on textiles might limit textile imports from a given country to 10 million garments per year. Once that limit is reached, textile imports from that country must stop for that year. Beginning in the 1960s, textile quotas were used by the United States and other countries to shield their domestic clothing industries from competition from low-wage countries. The phasing out of these quotas in the 1990s caused an upsurge in inexpensive clothing imports. Many U.S. apparel companies went out of business as a result, including the T-shirt makers of Florence, Alabama. Like tariffs, quotas are designed to protect domestic industries. But they do not raise revenue for the government. They may also lead to corruption and smuggling as producers look for ways to exceed quota limits. Like tariffs, import quotas raise prices for consumers as costlier domestic items replace cheaper imports once the quota limit is reached.

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President John F. Kennedy enacted a trade embargo in 1962 intended to pressure Cuba to overthrow the communist government of Fidel Castro. As of 2018, the embargo remained in effect, making it the longest trade embargo in American history.

Trade embargoes. A trade embargo imposes a ban on trade with a country or group of countries, usually for political reasons. For example, in 1960 the United States imposed a trade embargo on Cuba to protest its revolutionary government’s seizure of American-owned property. In 1986, the U.S. Congress imposed an embargo on South Africa to oppose its apartheid policy of racial segregation. Trade embargoes have a mixed record. When successful, they pressure countries to change their policies. South Africa, for example, abandoned its racial segregation policies when faced with trade embargoes from many countries. In contrast, as of 2018, the decades-long U.S. trade embargo against Cuba had failed to bring about a change in the Level: A

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country’s government or policies.

Voluntary export restraints. The fourth type of trade barrier is known as a voluntary export restraint, or VER. This type of barrier limits the quantity of a good that can be exported from a country during a specific time period. In effect, it is an export quota, selfimposed by the exporting country. In most cases, however, a VER is not truly voluntary. It is usually established at the insistence of an importing country. It is designed to avoid harsher restrictions, such as tariffs or import quotas. For example, Japan imposed a VER on its automobile shipments to the United States in the 1980s when faced with U.S. threats to restrict Japanese auto imports. The Debate over Trade Restrictions People have long debated the merits of free trade versus protectionism. Economists generally agree that free trade promotes economic growth and is good for consumers. Still, domestic producers, labor unions, and political leaders continue to make the case for trade restrictions. They base this position on a number of key arguments.

The jobs argument. This argument assumes that allowing cheap imports into a country destroys jobs by forcing domestic companies to cut costs, lay off workers, or even go out of business. Protectionists might point to the collapse of the Florence, Alabama, T-shirt industry to support this case. According to the jobs argument, highly paid workers in a wealthy country like the United States simply cannot compete with low-wage workers in poorer countries. The only way to protect American jobs is to make cheap imports more expensive by imposing higher tariffs or to limit their availability by imposing quotas. Economists reply that tariffs and quotas cost more jobs than they save. For example, in the 1980s the United States imposed tariffs on imported steel to protect the domestic steel industry. The tariffs led to higher steel prices. Higher steel prices raised the cost of producing goods made with steel, from pots and pans to automobiles. This hurt domestic producers of such goods, who had to compete with foreign producers using cheaper steel. By one estimate, the steel tariffs earned roughly $240 million in profits for U.S. steel companies and saved 5,000 jobs. But they cost domestic industries that use steel $600 million in profits and 26,000 jobs. 2020 Teachers' Curriculum Institute

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Most economists also dismiss the idea that American workers cannot compete with foreign labor. Low wages in poor countries, they say, reflect low productivity. The cost to an employer of a high-wage worker who is very productive may be less than that of a low-wage worker who is less productive. Free trade encourages firms to specialize in those activities in which their workers are relatively more productive. Finally, economists note that while free trade destroys some jobs, it also creates jobs. It does so by expanding the industries in which the United States has a comparative advantage. It helps U.S. export industries, since buying imports from foreign countries gives those countries the purchasing power to buy American goods. It also creates jobs for retailers and businesses that sell and service imported goods.

The national security argument. This argument states that industries that are vital to national security must be protected. Included in this category are defense industries and producers of critical resources like oil and steel. Some would even extend this argument to include the production of basic foods, such as wheat and corn. Those who make this argument say trade restrictions are needed to avoid dependence on foreign suppliers during times of conflict. Most economists would agree that when the country’s security is at stake, trade barriers may be justified to protect key industries. But they are skeptical when calls for such protection come from industry representatives rather than military or intelligence agencies. Industries that are facing stiff foreign competition have an interest in proclaiming their own importance to the country’s security.

The infant-industry argument. Sometimes a newly formed industry needs time to become competitive. According to this argument, such “infant industries” will eventually become strong enough to stand on their own. In the meantime, protectionists say, tariffs may be necessary to protect them from cheaper imports. Economists typically respond that even if one accepts this argument, it is difficult to put into practice. It requires that the government identify which infant industries will eventually make a profit and are therefore worth protecting. In reality, making this selection is notoriously difficult, and the process is all too easily influenced by politics.

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Figure 15.3A Trade restrictions do not just affect the industries they are meant to protect. They also have an impact on consumers and on producers in other industries. This table summarizes the costs and benefits of the four trade barriers. Overall, most economists say, the economic costs of trade restrictions outweigh the benefits.

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Some countries, such as Laos, produce goods in sweatshops, a type of factory where works are paid very little and often work in poor or unsafe conditions. Some may argue that trade should be restricted with a country that has sweatshops because their labor standards are much less restrictive than those in the United States.

Economists also object to the infant-industry argument on principle. New firms, they argue, must be willing to accept losses when starting up if they believe they can become profitable in the long run. Moreover, many new firms have grown into industry giants.

The unfair-competition argument. This argument asserts that trade is fair only if all countries play by the same rules. For example, protectionists argue that some countries “cheat” by providing subsidies to their industries to help them compete with foreign firms. They say that trade barriers are justified to protect domestic industries from subsidized foreign imports. Protectionists also contend that some countries “dump” their products in foreign markets to force competitors out of business. Dumping means selling a product for less than it cost to produce it. Dumping is considered an unfair trade practice by most trade organizations, and most countries disavow it. Economists typically reject both parts of the unfair-competition argument. First, they assert that the benefits to consumers of cheap imports outweigh the costs to domestic producers, regardless of Level: A

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whether the imported products are subsidized or not. Second, they say it is nearly impossible to detect dumping because it is difficult to determine a foreign firm’s costs. “Often,” write economists Campbell McConnell and Stanley Brue, “what appears to be dumping is simply comparative advantage at work.”

The protection-as-bargaining-chip argument. This argument states that trade restrictions can be a useful bargaining tool in trade negotiations with other countries. Its advocates claim that the threat of a tariff or import quota can be used to persuade another country to remove or reduce its barriers to trade. Economists point out that this strategy can easily backfire. When that happens— when the threat of a new trade restriction does not produce the desired result—the country faces a dilemma. It either has to make good on its threat and impose the restriction (which might harm its economic welfare) or back down (which can harm its reputation). Either of these results leaves the country worse off than before.

The environmental-and-labor-standards argument. Some people contend that countries with lax environmental or labor laws have an economic advantage over countries that must comply with stricter laws. To make trade fair, they say, countries with stricter laws should impose tariffs against countries that do not uphold similar standards. The problem with this argument, say most economists, is that lax standards are most common in the world’s poorer countries. These countries have few resources to devote to worker and environmental protection. As they develop their economies, in part through global trade, they will be able to pay more attention to labor and environmental standards. Restricting trade with such countries only slows the pace at which such improvements can be made. Why Trade Restrictions Are Still Widespread If the view of most economists is correct and trade restrictions do more harm than good, then why do political leaders and the general public still support them? The answer lies in the political process. Producers and workers who are threatened by foreign competition typically organize to seek trade protection. They lobby members of Congress and educate the public on the subject. On the other hand, those who benefit from free trade may not even realize that their interests are at stake. And so, they do little to oppose trade restrictions.

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The overall cost of tariffs and quotas typically greatly exceeds the benefits. It is not uncommon to find that it costs the public $200,000 or more a year to protect a domestic job that pays less than one-fourth that amount . . . In the political arena, the voice of the relatively few producers demanding protectionism is loud and constant, whereas the voice of those footing the bill is soft or nonexistent. —Campbell R. McConnell and Stanley L. Brue, Economics: Principles, Problems and Policies Reducing Trade Barriers Through International Agreements Countries do have incentives to promote free trade, however. The chief incentive is to be able to sell their products abroad and earn export revenues. Countries have negotiated international trade agreements to reduce trade barriers. Some trade agreements involve just two or three countries or a particular region. For example, the United States-Mexico-Canada Agreement, the Trump administration’s renegotiated version of the North American Free Trade Agreement, includes just Canada, Mexico, and the United States. The European Union, established in 1993, included 28 member countries by 2018. The first trade agreement to involve a large number of countries was the General Agreement on Tariffs and Trade. When adopted by 23 countries in 1948, GATT lowered tariffs on tens of thousands of goods. In 1995, the members of GATT formed the World Trade Organization. Since its formation, the WTO has overseen various international negotiations aimed at reducing trade barriers. It has also worked to resolve trade disputes among its members. By 2018, the WTO consisted of 164 member countries, all of which agree to abide by WTO rules.

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Figure 15.3B The United States has numerous trade agreements with other countries and is negotiating with more countries, including those in Europe and Asia. The Office of the U.S. Trade Representative is the government agency responsible for negotiating such agreements. This map highlights the countries with which the United States has a trade agreement with the status of the agreements as of 2018, and the year the agreement was made effective. As of the end of 2018, NAFTA remained in place and the USMCA had not yet gone into effect.

Foreign exchange occurs wherever people change money around the world. Currency exchange offices, such as this one at an international airport, are 2020 Teachers' Curriculum Institute

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4. How Is Global Trade Financed? For countries to trade goods and services, they must also trade their currencies. If you have ever visited a foreign country, such as Mexico, you know that you must exchange your dollars for Mexican pesos in order to shop while you are there. The same is true for U.S. businesses that want to buy goods or services in Mexico. Likewise, a Mexican firm that wants to buy American goods must trade its pesos for dollars. The process of converting one currency to another is known as foreign exchange. Without the exchange of currencies, little or no global trade would take place. Foreign Exchange and Exchange Rates Foreign exchange takes place on the foreign exchange market. This market is made up of major banks and financial institutions around the world that buy and sell currencies. Each currency traded in the foreign exchange market has an exchange rate. This rate indicates the value of one currency in terms of another. For example, if you can exchange one U.S. dollar for 10 Mexican pesos, the exchange rate is US$1 = 10 pesos. The Mexican peso exchange rate would be 1 peso = US$0.10. Exchange rates typically fluctuate based on supply and demand. If Americans are buying lots of goods and services from Mexico, they will need lots of pesos. Because the price of something generally rises with demand, a strong demand for pesos tends to raise the price of pesos in terms of dollars. That is, it will take more dollars to buy the same number of pesos. The exchange rate might fall from US$1 = 10 pesos to US$1 = 9 pesos. The dollar would then be worth less in pesos. When one currency loses value relative to another currency, we say depreciation has occurred. Conversely, if Mexicans are buying lots of U.S. goods and services, the demand for dollars in Mexico will increase. That, in turn, will cause the price of the dollar to rise relative to the peso. So, for example, instead of getting 10 pesos for one dollar, you might get 11 pesos. When one currency gains value relative to another currency, we say appreciation has occurred. Note that when comparing two currencies, Level: A

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the appreciation of one means the depreciation of the other. When a currency appreciates in value, it is said to get stronger. When it depreciates, it is said to get weaker. Thus, a strong dollar has a higher exchange rate and trades for more foreign currency than a weak dollar. Whether a country’s currency is strong or weak has important effects on its cross-border trade. When the dollar is weak, foreign goods and services cost more in dollars. This tends to discourage imports into the United States. At the same time, a weak dollar makes U.S. exports relatively cheap for other countries, since their currencies are strong relative to the dollar. Thus, a weak dollar is likely to boost U.S. exports. When the dollar is strong, the reverse occurs. Imports from other countries become cheaper, while exports become more expensive. Although many people regard a strong dollar as good and a weak dollar as bad, it is really a matter of perspective. A weak dollar can be hard on consumers, who pay more for imports, but good for those producers who primarily export their products. When the dollar is strong, on the other hand, consumers may benefit and producers may suffer. There are exceptions to this general rule. Producers who depend on imported parts for their products, for example, may not benefit from a weak dollar. And consumers whose jobs depend on exports may not benefit from a strong dollar. Generally, countries try to strike a balance between high and low exchange rates while achieving some stability relative to other currencies.

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Exchange Rate Systems: Fixed and Floating An exchange rate that fluctuates based on supply and demand is called a floating exchange rate. This is the dominant system in the world today. Some countries take a different approach, however. They establish a fixed exchange rate to keep their currency stable. Under a fixed system, the government typically fixes, or “pegs,” its currency to another major currency, such as the dollar. For example, Mexico might establish a fixed exchange rate of 10 pesos to the dollar and seek to maintain that rate rather than let the peso’s value float up and down on the open market. Both types of exchange rates have their advantages and disadvantages. The main advantage of floating rates is that they reflect supply and demand in the financial markets. The main disadvantage is that they are unpredictable. An unexpected rise or fall in a currency’s exchange rate can have negative effects on a country’s economy by disrupting trade. Fixed rates, on the other hand, are predictable. They allow businesses and the government to make economic plans based on a constant value for the currency. Nevertheless, a fixed rate system runs into trouble when a currency’s exchange rate no longer reflects what the market says it is worth. When this happens, a government may have to Level: A

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intervene in financial markets to preserve the value of its currency. It does so using reserves of currency, which it holds for this purpose. For example, if the value of the peso compared to the dollar were to fall too low, the Mexican government could buy pesos on the open market. It would pay for them with dollars from its currency reserves. This would increase the demand for pesos while reducing their supply, thus increasing their value. At the same time, it would increase the supply of dollars on the market, decreasing their value. The result would be to push up the value of the peso. Were the value of pesos to climb too high, the government could step in to devalue its currency. It would do so by selling pesos from its reserves for dollars. This action would increase demand for dollars while reducing their supply. And it would decrease demand for pesos while increasing their supply. The result would be a devaluation of the peso relative to the dollar. Since the 1970s, most industrialized countries, such as the United States and Japan, have allowed their currencies to float in a managed way. Other countries with less stable currencies have pegged them to a major currency, such as the dollar or the euro, the common currency of the European Union. Imports, Exports, and the Balance of Trade Another way countries try to manage the value of their currency is by regulating their balance of trade. Balance of trade is the difference between the value of a country’s exports and the value of its imports. Also known as net exports, it is calculated by subtracting imports from exports. A country’s balance of trade can be positive or negative. If a country exports more than it imports, it has a positive balance of trade, or a trade surplus. If it imports more than it exports, it has a negative trade balance, or a trade deficit. Figure 15.4A shows the U.S. balance of trade in goods and services over time. A trade surplus helps to strengthen a country’s currency. Think about what would happen if the United States had a trade surplus. The number of dollars coming into the United States from the sale of exports would exceed the number of dollars we send to other countries to pay for imports. As the supply of dollars held by people in other countries dropped, the value of the dollar would likely rise. In the same way, a trade deficit tends to weaken a country’s currency. Again, consider the situation of the United States, which has run a trade 2020 Teachers' Curriculum Institute

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deficit for years. To pay for all of its imports, the United States has to send more and more dollars to its trading partners. As the supply of dollars held by people in other countries rises, the value of the dollar is likely to drop. And so, by exporting more or importing less, a country can have some effect on the strength of its currency. Just as a weak currency is not necessarily bad, a trade deficit does not necessarily signal a struggling economy. In 2016, the U.S. trade deficit amounted to more than $500 billion. Yet, the United States also had the world’s largest economy that year.

Figure 15.4A This graph shows the U.S. balance of trade in goods and services from 1992 to 2016. Note the area in which the United States has a positive balance of trade. What does that say about this country’s comparative advantage in the global market?

Financing the U.S. Trade Deficit When the United States runs a trade deficit, it means that the country is buying more than it is selling in world markets. How does the country manage to do this year after year?

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Figure 15.4B Foreign direct investment is capital invested by foreign interests in another country’s businesses. FDI promotes economic growth and helps balance the U.S. trade deficit. • The bar graph shows the dollar value of FDI flowing into the United States from 1990 to 2016. • The line graph shows the dollar value of American FDI flowing into other countries.

The United States finances its trade deficit by borrowing dollars from foreign lenders and by selling U.S. assets to foreign investors. In other words, foreigners enable the United States to run deficits. They are willing and able to do this because they have so many surplus dollars from selling us their goods. Foreigners holding dollars can lend their dollars to the United States by buying Treasury securities or other types of bonds. In 2018, foreigners held more than $6.2 trillion in U.S. Treasury securities alone. Foreign investors can also purchase stock in American companies or buy U.S. assets, such as farmland and office buildings. Some foreign companies use their dollars to buy American companies or to establish new 2020 Teachers' Curriculum Institute

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businesses in the United States. Investment by a firm in a business enterprise in a foreign country is known as foreign direct investment (FDI). A German or Japanese auto company creating an assembly plant in the United States is an example of foreign direct investment. In 2016, FDI in the United States was around $372.5 billion. Concern About the U.S. Trade Deficit Many Americans are understandably concerned about trade deficits. Such concern is rooted in personal experience and common sense. After all, if you spend more than you earn, you go into debt. If you borrow to finance your debts, you go deeper into debt. This endless borrowing can get a person into serious financial trouble. Many people view the U.S. trade deficit in much the same way. The United States, they argue, cannot continue to run large deficits and finance them with foreign borrowing forever. At some point, we may have to pay off all that debt, which could prove painful. Moreover, many Americans do not like the idea of foreign firms owning and controlling U.S. land and businesses. Economists differ on the significance of the trade deficit and the resulting U.S. debt owned by foreigners. Thomas Sowell notes that the United States has been a debtor country for much of its history. In the 1800s, foreign loans and investment helped finance the country’s economic development. “There is nothing wrong with this,” he writes, and continues,

Neither the domestic economy nor the international economy is a zero-sum process, where some must lose what others win. Everyone can win when investments create a growing economy. There is a bigger pie, from which everyone can get bigger slices. —Thomas Sowell, Basic Economics So well and other economists point out that the trade deficit is not a problem as long as our economy grows. When times are good, other countries view the United States as a safe place to invest their dollars. But the deficit and debt could become an issue if the economy falters. Countries may then become less eager to make new loans to the U.S. government. And old loans will have to be repaid—by taxpayers like you. As Robert Frank and Ben Bernanke note,

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Foreign loans must ultimately be repaid with interest. If the foreign savings are well invested and the U.S. economy grows, repayment will not pose a problem. However, if economic growth . . . slackens, repaying the foreign lenders will impose an economic burden in the future. —Robert H. Frank and Ben S. Bernanke, Principles of Economics The global economy is bound to play a large role in your life. You are already a participant in that economy every time you buy goods made in other countries. And whatever career you choose, it is likely to involve the global marketplace in some way. Understanding how global trade works will help you make better choices. Whether you are hunting for the best deal or your perfect job, knowledge of the global marketplace will help you to make conscious and informed decisions.

Summary The United States plays an active part in the global economy. U.S. trade with other countries has expanded in recent decades and has contributed to economic growth both at home and abroad. Why is global trade growing in importance? Various factors have contributed to the growth of global trade. Chief among these are advances in transportation and communications, which have made it easier for countries to do business and move goods around the world. New and differentiated products have also stimulated global trade. What goods and services do countries trade? Manufactured products are the main category of exports among nations. Agricultural and mineral commodities—notably oil—are also important. Services in such areas as finance, transportation, education, and information also make up a key component of overseas trade. How and why do countries regulate trade? Although free trade makes economic sense, most countries find reasons to restrict trade. Usually they do so for political reasons, erecting trade barriers—such as tariffs and quotas—to limit imports in order to protect domestic industries. Such restrictions benefit specific industries at the expense of consumers and producers in other industries. How is global trade financed? Importers and exporters finance global trade by trading currencies on the foreign exchange market. 2020 Teachers' Curriculum Institute

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Exchange rates fluctuate based on supply and demand. Governments may try to influence rates through trade policies and other means. When countries have a negative balance of trade, or a trade deficit, they generally finance their deficit by getting loans or investment capital from abroad.

Regional Trade Blocs Over the past several decades, countries have negotiated agreements to promote trade and economic cooperation. Some of these agreements have resulted in the creation of regional trade blocs. A trade bloc is a group of countries with common economic interests and a desire to reduce trade barriers among its members. Trade blocs are also known as free-trade zones. This essay looks at the four largest trade blocs: the European Union (EU), the North American Free Trade Agreement (NAFTA), the Association of Southeast Asian Nations (ASEAN), and the Common Market of the South (Mercosur).

The EU The European Union was formed in 1993. It was built on the foundations of an earlier organization known as the European Economic Community or Common Market. The EU, which in 2009 included 27 member-states, seeks to integrate the nations of Europe into a single market and economic system. The EU has abolished most tariffs and other barriers to trade among its members. It has also removed restrictions on the movement of capital and labor within Europe. On January 1, 1999, it established a common currency, the euro, under a plan known as Economic and Monetary Union, or EMU. Various national currencies such as the German mark and the French franc were eventually eliminated. Although not all EU members have adopted the euro, the use of a common currency has eased trade and commerce among European nations. Overall, the EU's policies of free trade and economic integration have spurred productivity and economic growth within Europe. This growth has helped make Europe a more prosperous market for goods from around the world. However, the EU also maintains tariffs on some imports from countries outside the trade bloc. Thus, while it has opened up its internal trade, the EU retains some barriers to global trade.

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NAFTA The North American Free Trade Agreement, signed in 1994, unites the United States, Canada, and Mexico in a free-trade zone. Under NAFTA, the three member-countries agreed to eliminate most barriers to trade and investment. NAFTA has helped to boost trade and economic cooperation among the three nations. Since the agreement went into effect, regional trade has more than tripled. Much of this growing trade has been in agricultural goods. Trade in farm products between the U.S. and Mexico grew from $7.3 billion in 1994 to $20.1 billion in 2006. Trade in consumer and industrial goods has also increased. Critics of NAFTA feared the agreement would cause U.S. companies to relocate to Mexico to take advantage of lower wages and lax environmental controls. They believed that NAFTA would result in a loss of U.S. jobs and a decline of American industry. Though that may have occurred in some cases, overall employment and manufacturing output increased in the United States between 1993 and 2007. Most economists agree that NAFTA has benefited the U.S. economy.

ASEAN The Association of Southeast Asian Nations was founded in 1967. The five original member-states were Indonesia, Malaysia, the Philippines, Singapore, and Thailand. Since then, five more nations have joined ASEAN: Brunei, Vietnam, Laos, Myanmar (Burma), and Cambodia. ASEAN has two main goals: (1) to promote economic growth and cooperation and (2) to ensure peace and stability in the region. To achieve its first goal, the group has worked to create a single market in the region by lowering tariffs and other barriers to trade among its members. Although it has not yet eliminated all tariffs, ASEAN has forged a substantial trade bloc in Southeast Asia. The group also hopes to sign free-trade agreements with China, India, and Japan. If the China pact goes through, it would create the world's largest free-trade zone.

Mercosur Mercosur is a South American trade bloc that joins the countries of Argentina, Brazil, Uruguay, and Paraguay. It is the world's fourth largest trade bloc, after the EU, NAFTA, and ASEAN. Formed in 1991, Mercosur represents more than 250 million people and over three-fourths of 2020 Teachers' Curriculum Institute

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South America's total GDP. Mercosur has sought to reduce or eliminate tariffs on internal trade and to mediate in disputes between its member-states. It has also discussed creating its own bank to fund economic development in the region. Ultimately, the group hopes to create a free-trade zone throughout South America. Venezuela has been accepted as a member, though its membership had not been ratified as of early 2009. Bolivia has also been considered for membership. Associate members—countries with some preferential access to the Mercosur market—include Bolivia, Chile, Colombia, Ecuador, and Peru.

The Three Types of Industry and Their Distribution The economy can be divided into three broad sectors or types of industry: primary, secondary, and tertiary. Each sector represents a different type of production. This essay describes the three types of industry and explains some of the factors that determine their location, both in the United States and overseas.

Primary: Agricultural and Extractive Industries Primary industries are involved in the production or extraction of raw materials or commodities. The main primary industries are farming, fishing, forestry, and mining and quarrying. All these industries turn natural resources into basic goods, or primary products. For example, farmers grow wheat, which can then be used to produce many other food products. Miners extract minerals from the earth that can be used for other industrial purposes. Primary industries also include businesses that purify or process raw materials to convert them to a usable form. For example, lumber mills that turn logs into boards are a primary industry. So are cement plants that combine limestone, gypsum, and other minerals to produce cement. Fish-canning plants are also a primary industry, since they take a primary product—fish—and pack it for use as a basic food.

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Secondary industries are involved in manufacturing or assembly. They use primary products or manufactured components to produce finished goods. Secondary industries make everything from processed food products, vehicles, and clothing to gasoline and prescription drugs. Building construction is also a secondary industry. Secondary industries can be divided into two broad categories: light industry and heavy industry. Light industry includes such things as home construction, textile manufacturing, and electronics assembly. Heavy industry includes the manufacture of larger, more expensive goods such as cars, airplanes, and heavy machinery. The steel industry and major construction projects, such as bridges and dams, also fall into the category of heavy industry.

Tertiary: Service Industries Tertiary industries produce services rather than goods, though providing goods may be part of their service. Retail businesses, such as shops and online stores, are a tertiary industry. So are restaurants and hotels. Although these businesses offer goods to their customers, they do not actually manufacture anything. Other economic activities that belong to the tertiary sector include transport services, education, banking and finance, legal, insurance, and medical services. The entertainment industry is part of the service sector. So is government, which provides a variety of services at the local, state, and national levels—including police and fire protection, health services, and national defense.

The Distribution of Industry Various factors help determine the distribution of the different types of industry, both nationally and globally. In general, primary industries tend to be located in rural locations that are rich in natural resources, whereas secondary and tertiary industries are often found in urban areas. The economies of poorer or developing nations tend to rely on primary industries, whereas those of richer or developed nations tend to be based on secondary and tertiary industries. In recent decades, however, many manufacturing and service industries have relocated to the developing world as part of the globalization process. Primary industries are typically located in areas with good conditions for farming or the extraction of raw materials. In the United States, for example, the agricultural industry is centered in such regions as the Midwest and central California, which have abundant farmland and a 2020 Teachers' Curriculum Institute

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good growing climate. Much of the nation's forestry takes place in the South and West, where trees are plentiful. Mining occurs in regions that are rich in iron, gold, and other minerals. Primary industries are often important in poor nations that have natural resources and a large, unskilled labor force. Traditionally, these countries have lacked the financial and human capital necessary for large-scale manufacturing or services. Secondary industries are typically located in urban areas, which provide good access to markets and labor. Urban areas also have the infrastructure—power, water, roads and other transport facilities— required to produce and distribute goods. Historically most secondary industries were located in developed nations, which had the capital, technology, and markets to support them. Increasingly, however, manufacturing and assembly plants are moving overseas to take advantage of lower-cost labor. Tertiary industries also tend to be located in urban areas with a substantial market and a skilled, educated workforce. Large service industries are typically a feature of richer, developed nations rather than poorer, developing countries. Globalization has shifted this balance somewhat, however, as many multinational companies have set up service operations—such as financial and computer services—in the developing world. India is one notable example of a developing country that has attracted many multinational service companies, due to its highly educated workforce and relatively low wage rates.

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The Costs and Benefits of Globalization Do the benefits of globalization outweigh the costs?

Vocabulary Glossary Vocabulary Cards foreign debt debt forgiveness capital flow economic development developed country developing country least developed country extreme poverty

Introduction

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Globalization involves the incorporation of many economies and cultures.

Globalization is a complex process. At its heart, it represents the growing integration of economies and societies around the world. For some of us, the most visible sign of globalization may be the availability of products from many different nations in food stores and shopping malls. For others, it may be shuttered factories, as work once done in the United States moves to other countries. As economist David Hummels observes, our views of globalization are mixed.

The word globalization has been used to mean many different things. It may conjure up visions of fleets of container ships moving goods worth trillions of dollars across all the world’s oceans, giant multinational firms with operations in every time zone, brand names and advertisements known by consumers on six continents, and telephone call centers in India providing customer service to American consumers . . . To some, globalization also conveys broader concerns and even fears, such as the erosion of labor and environmental standards or the loss of national sovereignty to international institutions that are Level: A

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not accountable to citizens of any nation. —David Hummzels, Focus: Globalization Globalization is also controversial. To its supporters, the benefits of globalization far outweigh any costs. They argue that the easy movement of people, goods, ideas, and technology around the world promotes economic growth and reduces poverty. They also believe that globalization encourages global cooperation in efforts to solve broad social and environmental problems. Critics of globalization, in contrast, charge that its costs exceed its benefits. As evidence they point to a deteriorating global environment and the persistence of poverty in much of the world. Not only has globalization failed to solve these problems, they argue, but may well be making them worse. In November 1999, protesters gathered in Seattle, Washington, to disrupt a meeting of the World Trade Organization. The antiglobalization demonstrators blamed the WTO for contributing to a host of economic, social, and environmental problems, from job losses in the United States to global climate change. As they marched through the streets, they chanted, “Hey hey, ho ho, the WTO has got to go.” To clear the streets, Seattle police used tear gas and rubber bullets in what newspapers called the “Battle of Seattle.” This lesson examines the debate between supporters and critics of globalization. It also considers some of the costs and benefits of the globalization process for both people and the environment.

1. Who Are the Main Players in the Globalization Debate? At the Seattle protests, concerns about globalization focused on the World Trade Organization. However, the WTO is just one of many players in the globalization debate. These players can be divided into four main groups: international organizations, nongovernmental organizations, multinational corporations, and sovereign nation-states. International Organizations Some of the main targets of globalization critics are international organizations like the WTO. Other key players in this group are the United Nations, the World Bank, and the International Monetary Fund. 2020 Teachers' Curriculum Institute

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World Trade Organization. As the body mainly responsible for drawing up and enforcing international trade agreements, the WTO stands at the center of the globalization debate. Its critics argue that the WTO works to protect the interests of wealthy countries and corporations at the expense of poor countries. They also charge that WTO policies endanger the natural environment and the rights of workers. WTO officials see these charges as misguided. “Trade is the ally of working people, not their enemy,” declared WTO director-general Mike Moore at the Seattle gathering in 1999. “As living standards improve, so too does education, health, the environment and labor standards.”

The Kariba dam, built in Zimbabwe and finished in the late 1970s, was not initially one of the World Bank’s projects. However, in 2014, the World Bank invested in rehabilitating the dam to make it more modern.

United Nations. Founded at the end of World War II as a peacekeeping organization, the United Nations has become a key player in the globalization process. As part of its mission, the United Nations analyzes economic issues and provides aid to poor countries. It also brokers international agreements designed to protect the environment, defend human rights, and preserve cultural traditions. These activities put the United Nations squarely in the middle of the globalization debate. World Bank. Also founded as World War II drew to a close, the World Bank has seen its mission change over time. Its initial goal was to help Europe recover from the war. Later, its focus shifted to helping Level: A

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developing countries advance their economies. As part of this second effort, the World Bank has funded large projects aimed at improving the economic infrastructure of developing countries. Examples include construction of hydroelectric dams and highways. Critics charge that many of these projects have benefited wealthy business interests and corrupt governments far more than they have helped the poor. Critics also point out that some projects, such as a program to help settlers move into the Amazon rainforest, have led to widespread environmental destruction. Other projects, like dam building in Asia, have forced poor people to relocate due to the effects of construction. In response to such criticism, the World Bank has shifted its focus to projects more directly aimed at eliminating poverty.

International Monetary Fund. Founded at the same time as the World Bank, the International Monetary Fund has seen its mission evolve as well. Its first task was to reconstruct the world’s battered international banking system after World War II. Today, the IMF offers economic advice and assistance to countries with financial problems. The International Monetary Fund is often called on to help countries experiencing a financial crisis. Such a crisis typically arises when a government accumulates too much foreign debt. A country’s foreign debt is the amount of money it owes to lenders in other countries. When debt levels rise too high, a poor country may have trouble servicing its debt. Debt service is the series of payments of interest and principal a borrower agrees to pay a lender over the life of the loan. To make payments on time, a government may need to borrow still more money. But as soon as signs of trouble appear, lenders may demand higher interest on new loans. Or, they may stop loaning money to the government altogether. The result is a debt crisis. The IMF uses a two-pronged approach to end such a crisis. First, it acts as a kind of lender of last resort. The IMF agrees to loan money to the troubled government at a lower interest rate than other lenders are demanding. This enables the government to continue servicing its debt. Second, as a condition for such loans, the IMF requires the government to adopt austerity measures. Usually this means reducing the government’s budget deficit by cutting spending. Once this is done, the government has less need to keep borrowing more and more money. 2020 Teachers' Curriculum Institute

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Critics charge that such measures harm poor countries. When forced to cut spending, governments often eliminate programs that help the poor, such as food subsidies. As a result, critics say, the costs of IMF policies fall most heavily on those least able to bear them. The benefits, in contrast, flow to banks and other lenders in wealthy countries whose loans are protected. Critics also charge that IMF policies trap poor countries in a cycle of debt they can never repay. A better approach, they say, would be debt forgiveness, or the cancellation of debts owed to foreign lenders. Eliminating foreign debts, they argue, would help poor countries escape the debt cycle. Defenders of the IMF reply that no country is forced to accept an IMF loan with its austerity measures. Moreover, canceling debts would only reward the countries that have failed to control their budgets. It would also eliminate any incentive for poorly managed governments to make needed fiscal policy reforms.

The World Wildlife Fund works to conserve nature and wildlife. Here, the WWF is spreading awareness about panda conservation to people in Germany.

Nongovernmental Organizations Another set of players in the globalization debate consists of nongovernmental organizations. NGOs are nonprofit organizations that operate outside of governments. The term NGO often refers to organizations that focus on helping lift people out of poverty around the world. Funding for NGOs typically comes from member contributions and grants from private foundations. Level: A

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Many of the NGOs in the globalization debate are concerned about the effects of global trade on the environment. Among these are such groups as the Sierra Club, Greenpeace, and the World Wildlife Fund. Other NGOs speak out on social issues associated with globalization. Examples include Oxfam International, CARE, the Global Fund for Women, and Save the Children. The Seattle protests brought together representatives from hundreds of NGOs supported by students, farmers, and church groups. Members of labor unions were also there to voice their concerns about losing jobs to global trade. “I never got on with environmentalists,” commented a laid-off steelworker from Michigan, “until I realized we were all fighting for the same thing.” Multinational Corporations Multinational corporations are both central players in the globalization process and prime targets of globalization critics. Multinationals are companies that have a home base in one country and operations in other countries. These large companies promote globalization by moving goods, capital, information, and people across borders to do business. Some multinationals have economic assets that dwarf those of many nations around the world. As of 2016, 69 of the largest economic entities in the world, as measured by GDP and total revenue, were companies, not countries. The economic output of AT&T, for example, was slightly larger than that of Argentina. Apple ranked just above Belgium, and Exxon Mobil’s revenue was more than twice that of Portugal. The economic power of these giant corporations concerns critics of globalization. Critics fear that multinationals might become a law unto themselves, wielding power with little restraint from national governments. Critics also worry that in their search for profits, multinationals will move their operations to countries that are unable to protect their workers or the environment from abuse. The result, critics fear, will be a “race to the bottom” in terms of wages, working conditions, or pollution. Supporters of globalization counter that multinational corporations generate trade, investments, jobs, and other economic benefits in countries where those corporations do business. The multinationals also train workers in new technologies and business methods, increasing the host country’s human capital. In the 1970s, for example, Daewoo, a South Korean multinational, decided to expand its garment-making business to Bangladesh. The company invited 130 Bangladeshi workers to Korea to learn how to 2020 Teachers' Curriculum Institute

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make shirts. Over time, 115 of those workers left Daewoo and used what they had learned to set up their own garment companies. Clothing soon became Bangladesh’s leading export. By 2018, its garment industry employed about 3.6 million workers who produced $28 billion worth of clothing for export each year. Sovereign Nation-States The last major players in the globalization debate are the world’s sovereign nation-states. A nation-state is an independent political body with full authority over its territory and inhabitants. The members of the United Nations are all nation-states.

The United States appealed to the WTO regarding the European Union’s decision to ban the import of meat from hormone treated cattle. Critics of the WTO have claimed that decisions like this can override any country’s laws.

A nation-state, in theory, has the sovereign power to regulate trade and capital flows across its borders. Capital flows are movements of money and investments from one country to another. To secure the benefits of global trade, however, many nation-states have agreed to limit their use of trade barriers by signing free-trade agreements and joining the WTO. A frequent complaint about the WTO is that its rulings on trade barriers restrict national sovereignty. As one protester in Seattle put it, “The WTO can rule that a country’s laws and regulations are barriers to free trade, regardless of the fact that those laws were passed by the people or in the public interest.” Level: A

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This protester might have been referring to a decision made by the WTO a year earlier in a dispute over the use of synthetic hormones to stimulate the growth of cattle. The European Union (EU) had banned imports of meat from hormone-treated cattle as a health risk. The United States appealed the ban to the WTO, saying that it was an unfair restraint on trade. The WTO found no health risk and ruled that the ban was an illegal trade barrier. Regardless of how you feel about hormone-treated cattle, what is important is that the WTO’s ruling could not and did not force the European Union to change its policy. Members of the WTO retain their full sovereign powers. However, the ruling did give the United States the right to raise tariffs on European imports to make up for the cost of the EU ban to U.S. beef exporters. The Globalization Index As you would expect, some nation-states are more open to globalization than others are. To see how nations rank in this area, KOF Swiss Economic Institute has created a globalization index, which measures a country’s global outlook in economics, society, and politics. This globalization index ranks 207 countries based on these three dimensions of globalization. A country’s economic globalization score is based on its actual economic flows and economic restrictions. Factors that contribute to a country’s economic flows include trade and foreign investments as a percentage of GDP. Factors that contribute to a country’s economic restrictions include hidden import barriers and the average tariff rate. A country’s social globalization score considers factors such as how many people use the internet and watch television and how many McDonald’s restaurants and Ikea stores the country has per capita. To measure a country’s political globalization score, the index considers the number of embassies in a country and a country’s participation in international organizations. A country’s ranking in this globalization index indicates how much or how little it has opened itself up to trade and contact with other countries. Perhaps not surprisingly, the higher-ranked countries, such as the United States, Australia, and the nations of Europe, are among the world’s wealthiest. Lower ranked countries, such as India, Iran, and Kenya, are marked by widespread poverty. This contrast raises the question of cause and effect. Are the top-rated countries wealthy because they have embraced globalization? Or, have they embraced globalization as a means to grow wealthier?

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Figure 16.1 According to the globalization index, some countries are more global than others. The index ranks countries mostly based on how well each country interacts with the rest of the world economically, socially, and politically.

2. Has Globalization Helped or Hindered Economic Development? Most economists believe that globalization contributes to economic development by increasing trade and investment across borders. Economic development is the process by which countries increase their economic output and improve the lives of their people. Economic development brings with it improvements in social welfare, including better nutrition, health care, and education. However, these benefits have not been spread uniformly among the world’s more than 7.5 billion people. Measuring Economic Development The World Bank and IMF have a number of ways to measure economic development. Most of those methods focus on such economic indicators as per capita GDP. Using these indicators, these organizations are able to classify countries by level of development. The three general classifications most commonly used are developed, developing, and least developed countries.

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Developed countries. The world’s wealthiest nations are considered developed countries. A developed country has an advanced, industrial economy and a relatively high annual per capita GDP. The World Bank calls nations in this category high income countries. Developed countries typically have stable political and legal institutions. Their courts can enforce property laws and contracts. They also have public services that are essential for economic growth. These include power and water services, transportation systems, telecommunication networks, and schools. Although poverty exists in these countries, the gap between rich and poor is not as great as it is in poorer nations. The United States, Canada, Japan, Australia, New Zealand, Israel, and most of the countries in Western Europe are considered developed countries. Singapore, South Korea, Taiwan, and South Africa are included in this group as well.

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Since 2001, Brazil’s industrialization has expanded greatly, making it the sixth biggest economy in the world. This factory making tractors with high tech machinery is an example of how the country has industrialized.

Developing countries. The majority of nations in the world are developing countries. A developing country is in the process of modernizing its economy. Most people have enough income to meet their basic needs. However, they have less access to goods and services than the average person in a developed country. The World Bank has split developing nations into two separate categories, lower middle income countries and upper middle income countries, depending on their per capita GDP. Levels of development and wealth differ widely among developing nations. A few, sometimes called newly industrialized countries, are making a rapid transition from agricultural to industrial economies. China and Brazil are two examples. Others, such as Saudi Arabia and Kuwait, have high per capita GDPs because of their oil wealth, but they lag behind developed countries in other ways, such as human rights. A common characteristic of developing countries is a wide income gap between rich and poor. In Brazil, for example, a small percentage of wealthy families enjoy a high standard of living. Meanwhile, the majority of Brazilians live in poverty. Many developing countries are still struggling to develop governments that can ensure the rule of law. Examples include Kenya, Lebanon, and Peru. In addition, their public services may not be well developed. As a Level: A

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result, many of their people may lack access to electricity and clean water.

Least developed countries. A smaller group of the world’s poorest nations are classified as least developed countries. A least developed country, or LDC, has barely begun to modernize its economy. Poverty is widespread and often severe. The World Bank calls nations in this category low income countries. Most of the people in LDCs earn a meager living from subsistence agriculture. They raise crops or livestock mainly for personal consumption rather than for sale. The great majority of these countries are in Africa. Liberia, Ethiopia, and Mali are a few of Africa’s very poor countries. Most of the remaining LDCs are located in Asia, including Afghanistan, Cambodia, and Nepal. The Human Development Index The United Nations has developed a broader approach to classifying nations. This approach, the Human Development Index, is based on the belief that people are the real wealth of nations. The United Nations sees economic development as a means to help people develop their full potential and lead productive lives—but not as an end in itself. The HDI measures a country’s level of human development along three dimensions. The first is life expectancy at birth, an indicator that reflects the general health of a population. The second dimension is education. The level of education is measured by a combination of how many years students are expected to attend school and the average number of years adults age 25 years and older actually attended school. The third dimension is standard of living. This dimension is measured by looking at a country’s gross national income per capita. The more money people have to spend, the better off they are in terms of material goods. These three measures are combined to arrive at a country’s overall HDI ranking. The map in Figure 16.2 shows how 187 countries scored on the Human Development Index in 2017. The top-ranked country in the “very high human development” category was Norway. The United States ranked thirteenth. The “high human development” category includes countries such China and Mexico, while the “medium human development” category included Iraq and India. Many of the countries in the “low human development” category were all located in Africa. Other countries in this category include Haiti, Papua New Guinea, and 2020 Teachers' Curriculum Institute

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Afghanistan.

Figure 16.2 The Human Development Index is based on the idea that a country’s true wealth is its people. The index rates countries on three dimensions: life expectancy, education, and living standards. This map shows the HDI rankings in 2017.

The Costs of Globalization for Poor Countries However one measures development, it is clear that globalization has not ended global poverty. Between 1990 and 2017, a period of rapid globalization, many developing countries experienced healthy GDP growth. But not all of them did. During this same period, per capita income in some LDCs fell or grew at a rate much slower than that of the rest of the world. In a report released not long after the Seattle protests, however, Oxfam International, an NGO working to help the world’s poorest countries, observed,

Over the past twenty years the income gap between people living in the LDCs and in the industrialised world has widened. Twenty years ago, the ratio of average income in the LDCs to average income in the industrialised world was 1:87. Today it is 1:98, and the gap is widening at an accelerating rate. Level: A

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—Oxfam International, “Rigged Trade and Not Much Aid: How Rich Countries Help to Keep the Least Developed Countries Poor,” 2001

Extreme poverty affects many people around the world. Many living in these conditions may not be able to afford even the most basic supplies, such as food.

To critics of globalization, such statistics are evidence that free trade is hurting, not helping, poor countries. These critics pointed out that as of 2015, over 736 million people—around one-tenth of the world’s population—lived in extreme poverty. The World Bank defines extreme poverty as a state of severe economic hardship in which people live on less than $1.90 per day. Globalization hurts poor countries, critics say, because most trade agreements have been written to serve the interests of wealthy countries, not LDCs. As Oxfam pointed out in its 2001 report,

Average tariffs in the EU, the United States, Canada, and Japan . . . are relatively low, at approximately five per cent. However, the average obscures very high tariffs in sectors of most relevance to poor countries. Tariffs on some agricultural commodities are more than 300 per cent in the EU and, as in the case of groundnuts [peanuts], over 100 per cent in the USA. The products that LDCs are best able to export tend to be farm products and goods that are easy to manufacture, such as clothing. As long as wealthy countries are able to block imports of these products with high tariffs and import quotas, globalization will remain, as its 2020 Teachers' Curriculum Institute

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critics maintain, a game with “rigged rules” favoring the wealthy. The Benefits of Globalization for Poor Countries Supporters believe that globalization holds out the best hope for relieving poverty around the world. Economics writer Charles Wheelan summed up the benefits of trade for poor countries as follows:

Trade paves the way for poor countries to get richer. Export industries often pay higher wages than jobs elsewhere in the economy. But that is only the beginning. New export jobs create more competition for workers, which raises wages everywhere else. Even rural incomes can go up; as workers leave rural areas for better opportunities, there are fewer mouths to be fed from what can be grown on the land they leave behind. Other important things are going on, too. Foreign companies introduce capital, technology, and new skills. Not only does that make export workers more productive; it spills over into other areas of the economy. Workers “learn by doing” and then take their knowledge with them. —Charles Wheelan, Naked Economics As the pace of globalization has picked up, GDP growth in poor countries has often exceeded that of wealthy countries. In 2018, for example, the World Bank projected a growth rate for developing countries of about 4.5 percent, compared to only 2.2 percent in highincome countries. Growth in many LDCs was even higher. However, some poor countries, like Malawi, saw their per capita GDP drop through 2015 because their populations grew faster than their economic output. That trend changed by 2016, with GDP outpacing population growth due to improved agricultural conditions. The benefits of globalization are also reflected in the Human Development Index. A number of countries with low HDI scores in 1985 have improved significantly since then. Examples include China, India, and Indonesia. Many economists attribute this improvement to the fact that these countries opened themselves up to global trade.

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Globalization has also helped lift millions of people out of poverty. The number of people living in extreme poverty has declined since 1981. This is true despite the addition of more than a billion people to the world’s population in the same time period. Supporters of globalization recognize that the benefits of opening up poor countries to trade come with costs. Small businesses may fail when faced with competition from giant multinationals. Poor farmers may not be able to compete with factory farms in rich countries. People who move from farms to cities in search of work may find life there harsher than it was in their rural villages. “It is necessary to acknowledge that globalization benefits people unevenly,” wrote IMF official Flemming Larsen, “and that it can and does produce losers as well as gainers.” On the whole, however, supporters argue that globalization has produced—and will continue to produce—far more gainers than losers. The Four Asian Tigers: A Case Study of Export-Led Development Among the greatest gainers benefiting from globalization are the four economies nicknamed the Four Asian Tigers. The name refers to the countries of South Korea, Singapore, and Taiwan, along with the former British colony of Hong Kong. In the 1960s, all four were relatively poor. Today, they rank among the world’s developed economies. Beginning in the 1970s, the Tigers adopted an economic model known 2020 Teachers' Curriculum Institute

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as export-led development. This model emphasizes the production of goods for export as a way of expanding an economy. The sale of exports brings in money to buy machinery for factories. With the new machines, more goods are produced, which adds to economic growth. Following a pattern established by Japan after World War II, the Tigers developed export industries that took advantage of their low labor costs. South Korea, for example, became a major producer of clothing and sneakers. Taiwan built factories that assembled electronic goods. At the same time, their governments kept tariffs high to protect their new industries from foreign competition. The result was two decades of spectacular economic growth for the Four Asian Tigers. Between 1970 and 1989, the average annual GDP growth in the Tigers ranged from 7 to 10 percent. In contrast, the world average growth rate hovered between 3 and 4 percent. As their economies grew, the Tigers invested heavily in education and other services to improve the lives of their citizens. As a result, their levels of human development rose rapidly. The success of the Four Asian Tigers was so impressive that the IMF and World Bank began recommending the export-led development model to their clients. From China to Chile, developing countries embraced the new model. By the 1990s, the Tigers faced fierce competition from countries like Vietnam and Bangladesh, which had even lower wage rates. As a result, the Tigers’ GDP growth began to slow. Critics of export-led development point to a number of problems with this model. The most obvious is that it depends on a high level of demand for exports in wealthy countries, especially the United States. If that demand drops because of an economic downturn, countries that rely on U.S. consumers to buy their exports will also suffer. As has often been observed, “When America sneezes, the world catches a cold.” During the 2008 recession, the Four Asian Tigers were hit hard as exports and GDP both dropped significantly. By 2018, their economies were once again increasing, thanks to expanding exports. For example, Singapore’s economy is expected to grow by 2.7 percent in 2019, and the other countries’ economies were also projected to grow at similar rates.

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Singapore is one of the Four Asian Tigers—along with South Korea, Taiwan, and Hong Kong— that benefited from export-led development. As Singapore’s economy grew, gleaming skyscrapers replaced older slums. In 2018, Singapore was listed as the second wealthiest country in the world, as measured by per capita GDP. The United States ranked 11 on the same list.

3. Has Globalization Helped or Hurt the Environment? Many of the protesters at the 1999 WTO meeting in Seattle were concerned about globalization’s effects on the environment. To show their concern, some came dressed as sea turtles. These costumes were a reference to a WTO decision made the previous year. The WTO ruling involved a U.S. law designed to protect sea turtles. The law banned imports of shrimp caught in nets that also trap and kill sea turtles. Asian countries that depend on shrimp fishing charged that the U.S. law violated WTO trade agreements. The WTO ruled that the shrimp ban, like the EU’s ban on hormone-raised beef, was an illegal trade barrier. Unlike the European Union, however, Congress chose to revise U.S. law 2020 Teachers' Curriculum Institute

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to comply with the WTO ruling. Its decision to do so upset environmentalists seeking to protect an endangered species. It also underscored what critics saw as the WTO’s indifference to environmental issues. Economic Development Creates Environmental Problems The plight of sea turtles caught in shrimp nets is a reminder that economic development is hard on the environment. Countries exploit natural resources and develop industries to promote economic growth. But such development may also cause pollution, destroy landscapes, and endanger wild species. Almost all human activity has some impact on the environment. When farmers clear forests and grasslands to plant crops, they are also destroying the habitats of plants and animals. As developing countries shift from agriculture to industry, their environmental problems multiply. If left unregulated, factories spew smoke into the air and pour toxic waste into waterways. The latest environmental challenge confronting the world is climate change. This term refers to variations in Earth’s overall climate over time, ranging from decades to millions of years. Historically, climate change was caused by natural processes. Such processes include volcanic eruptions and variations in the intensity of sunlight reaching the planet’s surface. Many scientists conclude that human activity is causing global climate change. The main culprit is the production of greenhouse gases. The burning of fossil fuels in power plants, factories, and vehicles accounts for a large percentage of greenhouse gas production. When fossil fuels like coal, oil, and natural gas are burned, they release carbon dioxide and other gases. These gases trap the sun’s energy in the atmosphere, behaving like a greenhouse. In 2015, nations from around the world met in Paris to plan how to limit climate change to less than 2 degrees Celsius over the course of the next century. Environmental writer Fred Pearce detailed the effects of this global climate change:

Melting glaciers and precipitation are causing some rivers to overflow, while evaporation is emptying others. Diseases are spreading. Some crops grow faster while others see yields slashed by disease and drought. Strong hurricanes are becoming more frequent and destructive . . . Clashes over dwindling water resources may cause conflicts in Level: A

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many regions. As natural ecosystems—such as coral reefs —are disrupted, biodiversity is reduced. Most species cannot migrate fast enough to keep up, though others are already evolving in response to warming. —Fred Pearce, “Instant Expert: Climate Change,” NewScientist.com The Costs of Globalization for the Environment Environmentalists do not blame all of these problems on global trade. But they worry about the impact that rapid economic growth has on the environment. By putting profits first, environmentalists believe, markets often overlook the environmental costs of economic activity. As one environmental economist wrote,

Though the market is a powerful tool for economic progress, where its edges meet the planet it is mainly [used] as a saw, shovel, or smokestack— as an instrument of destruction rather than protection. —David Malin Roodman, The Natural Wealth of Nations: Harnessing the Market for the Environment, 1998

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Figure 16.3A Between 1950 and 2016, world carbon emissions from burning fossil fuel rose from 1.6 billion tons to 9 billion tons a year. For most of that period, the United States was the world’s top emitter. By 2006, China had moved into the top spot and the country remains there as of 2017. However, on a per capita basis, the average American emitted more than twice as much carbon dioxide as did the average Chinese person.

Environmentalists are not opposed to economic development. But they believe development should be sustainable over time. Sustainable development is designed to meet people’s present needs without having a negative impact on future generations’ ability to meet their needs. For example, a lumber company that plants as many trees as it cuts down each year is practicing a sustainable development model. Unfortunately, say environmentalists, most current development is not sustainable. Globalization is making millions of people in the developing world richer, increasing the global demand for luxury goods such as computers and cars. The same is true for the fossil fuels needed to power them. “Trying to meet that kind of demand,” cautioned environmentalist Bill McKibben, “would stress the earth past its breaking point.” Environmentalists also worry that globalization may encourage multinational corporations to move their operations to “pollution havens.” A pollution haven is a country that attracts polluting industries because of its weak or poorly enforced environmental laws. Level: A

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“‘Pollution havens’ . . . have failed to materialize,” reported the World Bank in 2000. “Instead, poorer nations and communities are acting to reduce pollution because they have decided that the benefits . . . outweigh the costs.” But the possibility that such havens might emerge still remains a concern in 2018. More worrisome yet is the link between globalization and climate change. Moving people and goods around the globe by air and sea produces more than 6 percent of the world’s carbon emissions. And as the economies of developing countries grow, their consumption of fossil fuels increases as well. This adds still more greenhouse gases to the atmosphere. If nothing is done to reduce these emissions, environmentalists warn, the effect on the environment could be devastating. “In this century, human activity could trigger an irreversible melting of the Greenland ice sheet and Antarctic glaciers,” wrote Fred Pearce. “This would condemn the world to a rise in sea level of six metres—enough to flood land occupied by billions of people.”

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Figure 16.3B The environmental Kuznets curve illustrates a theoretical relationship between per capita income and the quality of a country’s environment. • As incomes begin to rise, environmental quality declines. This may be due to industrialization or lifestyle changes as people begin to consume more. • At some income level, people begin to demand a cleaner environment. From that point on, increased per capita income leads to improved environmental quality.

The Benefits of Globalization for the Environment Supporters of globalization recognize that development has environmental costs. They argue, however, that the best way to address those costs is not by slowing economic growth. The answer, they say, is to speed it up. To explain why, economists point to the environmental Kuznets curve. This theoretical curve shows pollution increasing as a country begins to industrialize. When incomes start to increase, people are more interested in raising their living standards than in controlling pollution. As they grow wealthier, however, this attitude begins to change. People Level: A

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become concerned about dirty air and waterways and demand that their governments do something about it. The wealthier that people become, the more resources they seem willing to devote to improving the environment. There is historical evidence suggesting that people will do more to protect their environment as they grow richer. The city of London, for example, had far worse air pollution a century ago than it does today. Lake Erie was pronounced “dead” in the 1960s. Today, the lake has one of the world’s largest freshwater fisheries. And in 2008, China’s government announced that it was shifting from growth at the expense of the environment to “putting equal emphasis on both,” which has led to reductions of air pollution and greenhouse gas emissions. Given this history, some economists describe a clean environment as a luxury good. However, they also note that the relationship between income and environmental protection is strongest for visible pollution. Examples include smoggy skies and sewage-choked rivers. It is weaker for problems that people do not see every day, such as carbon emissions and loss of forests. “The quick and dirty rule seems to be that if you can’t see it or smell it in your local urban neighborhood,” noted economics writer Andrew Leonard, “then, no matter how rich you are, you aren’t going to do much about it.” Globalization may also benefit the environment by fostering international cooperation to solve problems. For example, in 1985, British scientists discovered that synthetic chemicals were thinning the ozone layer in Earth’s atmosphere. The ozone layer protects the planet from harmful ultraviolet rays given off by the sun. Overexposure to these rays can cause skin cancer and damage eyes. Recognizing the danger, world leaders met in 1987 to sign the Montreal Protocol on Substances that Deplete the Ozone Layer. Hailed by the U.S. Environmental Protection Agency as “the world’s most successful international environmental treaty,” the protocol ended production of the most harmful chemicals. Since the treaty went into effect, the thinning of the ozone layer has stopped. Full recovery, however, may take many lifetimes.

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As part of its effort to protect whales, the International Whaling Commission promotes whale watching as “a sustainable use of cetacean [sea mammal] resources.” Whale-watching tours earn welcome tourist dollars for former whaling communities. At the same time, these tours allow the public to see whales in their natural environment.

Whaling: A Case Study of Global Environmental Cooperation Another example of global cooperation to protect the environment is the Save the Whales campaign. Begun in the 1970s, this campaign brought together the International Whaling Commission, sovereign nation-states, and NGOs in an effort to protect endangered whale species. For centuries, whales had been hunted for their meat and oil. By the 1950s, however, modern whaling methods had brought many whale species to the brink of extinction. The number of blue whales, for example, had dropped from between 30,000 and 40,000 in the 1930s to 2,000 or fewer in the 1960s. The International Whaling Commission was established in 1946 to manage whale harvests. In 1982, under immense pressure from NGOs, the commission imposed a moratorium, or ban, on whaling. The moratorium applies only to commercial whaling. Whales may still be caught for scientific purposes or by native peoples who depend on whales for food. Level: A

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The Save the Whales campaign was evidence of the growing power of NGOs. Working together, anti-whaling groups persuaded people around the world that protecting whales was important. As a result of the hunting ban, the stocks of many whale species are no longer in decline. Some are even on the rebound. The world has done less well in protecting other forms of marine life. Because of overfishing by commercial fishing fleets, around 75 percent of fish stocks are being harvested at unsustainable levels. As a result, many fish species are in danger of extinction. Making matters worse, the oceans are being polluted at an alarming rate. Whether the world can come together to save the oceans and marine life, as it did whales, remains an open question.

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American business interests, including the entertainment industry, have carried U.S. culture to the far reaches of the globe. Disneyland is one example. The first overseas Disneyland opened in Tokyo, Japan, in 1983. Soon, other parks were developed: Disneyland Paris, Disneyland Hong Kong, and Disneyland Shanghai.

4. Does Globalization Enrich or Threaten Local Cultures? On August 12, 1999, a group of farmers and antiglobalization activists drove tractors into a town in southwestern France. There they destroyed a McDonald’s restaurant that was under construction, Level: A

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dumping the rubble on the outskirts of town. “I believe that the French people,” declared Jose Bove, the group’s leader, “are with us in this fight against junk food and against globalization.” For Bove and his supporters, globalization—as symbolized by McDonald’s— was a threat to French culture. In their eyes, it undermined local traditions of fresh food and small-scale agriculture. For many other people, however, globalization is a positive force that enriches local cultures. The Global Reach of American Culture Bove’s attack was not only directed at globalization. It was also an assault on Americanization—the spread of American customs and culture to other countries. For many of its critics, globalization and Americanization are one and the same. Over the past several decades, American fads, foods, and fashions have spread rapidly around the world. Much of this Americanization has been carried out by multinational corporations. American-based companies can be found in almost every corner of the globe. On a visit to Beijing, China, anthropologist James L. Watson noted,

Looming over Beijing’s choking, bumper-to bumper traffic, every tenth building seems to sport a giant neon sign advertising American wares: Xerox, Mobil, Kinko’s, Northwest Airlines, IBM, Jeep, Gerber, even the Jolly Green Giant. American food chains and beverages are everywhere in central Beijing: Coca- Cola, Starbucks, . . . BaskinRobbins, Pepsi, TCBY, Pizza Hut, and of course McDonald’s. —James L. Watson, “China’s Big Mac Attack,” Foreign Affairs, 2000 Americanization is also evident in popular culture. American music, movies, and television shows are popular throughout the world. Some of these cultural products have been created with the global market in mind. Such globalized films may deal with international issues or feature non-American actors in starring roles. Commercial interests are not the only force driving the spread of American culture. Language also plays a major part. English is one of the most widely spoken languages in the world, used by as much as 1.5 billion people, or one-fifth of the world’s population. Nevertheless, the spread of American culture concerns many critics of globalization. Some see it as cultural imperialism, the imposing of 2020 Teachers' Curriculum Institute

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one country’s culture or language on another country. The Costs of Globalization for Local Cultures The main criticism of globalization from a cultural perspective is that it weakens local traditions. Like Jose Bove, many people worry that their own way of life will be lost amid a flood of imported culture. Critics point to the rapid extinction of languages as one cost of globalization. As the English language and Western cultural influences spread across the world, many smaller, local languages are dying out. Language experts predict that more than half of the world’s 7,000 languages will disappear by the end of the century. Language is an important vehicle for the preservation of culture. This is especially true for native peoples in the developing world, who may not have a written language. When a language dies, it takes with it a wealth of human knowledge, especially about the natural world. “Most of what we know about species and ecosystems is not written down anywhere,” observed linguistics professor David Harrison. “It’s only in people’s heads. We are seeing in front of our eyes the erosion of the human knowledge base.” Along with the loss of language, many peoples are seeing their own traditions crowded out by cultural imports. In many villages around the world, for example, people have swapped their traditional clothing for jeans and T-shirts. Teenagers are more interested in television shows and popular music from abroad than traditional folklore and music. They choose hamburgers and pizza over traditional foods. This problem is not limited to developing nations. In the 1960s, U.S. movies earned only about 35 percent of European box office revenues. By 2012, American films produced 62.8 percent of the ticket sales in the EU. In response, some countries have enacted laws to preserve local cultural products. France and Canada, for example, have imposed limits on cultural imports, such as American magazines, movies, and television programs. Cultural evolution is nothing new, of course. It is a natural process that has been taking place for thousands of years. But critics warn that globalization is speeding up the process of cultural change, often with commercial interests in mind. They fear that the rich, vibrant mosaic of world culture will be replaced by a bland “McWorld,” where all cultures resemble that of the United States.

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As Julia Galeota, who at the age of 17 wrote a prize-winning essay on cultural imperialism, observed,

Throughout the course of human existence, millions have died to preserve their indigenous culture. It is a fundamental right of humanity to be allowed to preserve the mental, physical, intellectual, and creative aspects of one’s society. A single “global culture” would be nothing more than a shallow, artificial “culture” of materialism. —Julia Galeota, “Cultural Imperialism: An American Tradition,” 2004 The Benefits of Globalization for Local Cultures Supporters of globalization see a different result from the interaction of world cultures. They contend that globalization enriches local cultures by exposing people to new ways of doing things. Rather than a bland “McWorld,” they say, the result is a “global village,” where cultures share ideas and customs but retain their distinct identities. “Critics of cultural imperialism charge that rich cultures dominate poor ones,” wrote economist Tyler Cowen. What they fail to see is the 2020 Teachers' Curriculum Institute

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degree to which “local culture commands loyalty.” In India, for example, domestic recordings dominate the music market. “Western culture often creates its own rivals,” Cowen observed, “by bringing creative technologies like the recording studio or the printing press to foreign lands.” Although globalization is often seen as a one-way flow—from rich to poor nations—it goes the other way, too. Customs and traditions from developing nations also influence the developed world. The fact that restaurants in the United States serve food from Thailand or Ethiopia is a sign of globalization. So is the fact that Americans watch Bollywood movies from India, listen to Afro-pop music from Nigeria, and furnish their homes with crafts from Indonesia. Artists and artisans in developing countries benefit from the chance to sell their products in the developed world. By gaining a larger market for their work, many are able to preserve their art, music, and traditional crafts.

Due to globalization, many different types of cuisines can be found in the United States. In many cities, you can find restaurants specializing in Ethiopian cuisine, shown in the image below.

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English or eat at McDonald’s. People make such choices voluntarily. “China has become more open partly because of the demands of ordinary people,” observed Watson. “They want to become part of the world.” In Nepal, the people who live near Mount Everest have adopted new customs through contact with foreign tourists. Mountain climber Jon Krakauer sees some of these changes as negative. But he also says that local people have benefited from global contact. Money from tourism and grants from inter-national organizations have funded new schools, medical clinics, and many other improvements. Krakauer wrote,

Most of the people who live in this rugged country seem to have no desire to be severed from the modern world or the untidy flow of human progress. The last thing [they] want is to be preserved as specimens in an anthropological museum. —Jon Krakauer, Into Thin Air, 1997 Cultural diffusion—the process of sharing ideas and knowledge across cultures—is often disruptive. But it is also productive and leads to new ways of life. It can even help spread universal ideals, such as respect for human rights and freedoms. As Cowen observed,

Culture is not a zero-sum game, so the greater reach of one culture does not necessarily mean diminished stature for others. In the broad sweep of history, many different traditions have grown together and flourished. American popular culture will continue to make money, but the 21st century will bring a broad mélange of influences, with no clear world cultural leader. —Tyler Cowen, “Some Countries Remain Resistant to American Cultural Exports,” New York Times, Feb. 22, 2007

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As McDonald’s expands into new countries, it must learn how to adapt to the local culture. Many people in India eat a vegetarian diet due to religious or moral convictions. Because of this, McDonalds opened its first vegetarianonly restaurant in India.

McDonald’s: A Case Study of Cultural Adaptation McDonald’s is a powerful symbol of globalization for supporters and critics alike. The American fast food chain has more than 36,000 outlets in 120 countries around the world. Many critics claim that McDonald’s imposes American cultural values wherever it goes, but the reality is more complex. Although McDonald’s has brought changes to other countries, it has also adapted to local cultures. Everywhere McDonald’s sets up a branch, it follows certain standard practices. The menu is the same, serving burgers, fries, and shakes. Over time, however, many branches have changed their menus to suit local tastes. In Norway, you can get a salmon sandwich. In India, where many people do not eat beef or pork, you can order a mutton burger, called a Maharaja Mac. Or, if you do not eat meat, you can get a spicy vegetarian patty made of peas and potatoes. French diners can order espresso coffee and brioche along with their burgers and fries. The style of the restaurants can vary, too. In France, for example, many branches have been remodeled to reflect local architecture. “Far from being cookie-cutter copies,” Shirley Leung reported in The Wall Street Journal, “each of the remodeled restaurants features one of at least eight different themes— such as ‘Mountain,’ complete with a woodbeam ceiling reminiscent of a ski chalet. The company has even begun Level: A

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to replace its traditional red-and-yellow signs with signs in muted tones of maroon and mustard.” At the same time, McDonald’s has had an impact on local cultures. In China, for example, people do not traditionally celebrate children’s birthdays. After McDonald’s introduced American style birthday parties, however, many Chinese families adopted the custom. McDonald’s also introduced a higher standard of cleanliness— including clean public bathrooms—than was typical of Chinese restaurants. As a result, many Chinese customers began demanding similar standards of hygiene elsewhere. One custom the Chinese have not adopted is the “eat and run” style of dining typical of a McDonald’s in the United States. At Chinese branches, customers may linger for hours, socializing, reading the newspaper, or doing their homework. Such behavior would be unusual, and probably discouraged, at an American fast food restaurant. All of this suggests that globalization is neither simple nor predictable. It is a complicated process, with many costs and benefits, that is changing the world in unforeseen ways. What does seem clear is that as long as countries continue to trade and interact, globalization in some form will continue. As economist Lester Thurow wrote,

Fifty years from now few of us will be apt to say we work in the U.S. economy or the Japanese economy. We live in the United States or Japan, but we work in the global economy. —Lester Thurow, Fortune Favors the Bold: What We Must Do to Build a New and Lasting Global Prosperity, 2003

Summary Globalization means many things to many people. In essence, it is the integration of economies and societies around the world. Critics emphasize its costs, however, while supporters point to its benefits. Who are the main players in the globalization debate? Four main groups play key roles in globalization: (1) international organizations, such as the World Trade Organization; (2) nongovernmental organizations, such as the World Wildlife Fund; (3) multinational corporations, such as McDonald’s; and (4) sovereign nation-states. 2020 Teachers' Curriculum Institute

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Has globalization helped or hindered economic development? For many developing countries, globalization has been the key to growing their economies and raising living standards. However, some of the world’s lessdeveloped countries have failed to experience such economic gains. Has globalization helped or hurt the environment? Although globalization is not the root cause of most environmental problems, it may contribute to them by encouraging industrialization. However, as countries develop, they also begin to do more to protect the environment. Globalization may help solve problems like climate change by promoting international cooperation. Does globalization enrich or threaten local cultures? Globalization brings cultures together in ways never experienced before. In some cases, the flood of Western products and ideas may crowd out local traditions and customs. At the same time, globalization enriches cultures by introducing new ideas, technologies, foods, and arts that can be adapted for local use and enjoyment.

Responsible Consumption: The Case of Electronic Goods This essay examines the responsible purchase, use, and disposal of personal and business property, with a focus on consumer electronics. It also considers the economic impact of obsolescence—the state of being out of date and no longer useful—resulting from technological innovation.

Economic Freedom and Consumer Responsibility In a market economy, individuals and businesses enjoy economic freedom. They have a right to make decisions about how they use their resources. They can buy and sell property freely, without government intervention. Nevertheless, consumers also have responsibilities with regard to their property. For example, it is not responsible, or legal, to operate a vehicle that violates state pollution standards. Nor is it responsible, or legal, to get rid of a vehicle by leaving it at the side of the road. Both these actions violate the rights of others to live in a clean and safe environment. Consumer responsibility also reflects sound economic principles. An Level: A

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efficient economy uses resources wisely and productively, producing the minimum waste possible and limiting stress on the environment. In the same way, a responsible consumer conserves resources, using them in a way that exploits their full value. Consumer responsibility also relates to personal finances. Anyone who has ever spent money unwisely knows that excessive spending undermines a household budget. The decision to limit consumer spending and live within one's means is an example of responsible consumer behavior.

Why Consumer Electronics? The market for electronic goods—products such as televisions, computers, and cell phones—provides a useful case study in consumer responsibility. This is true for several reasons. First, electronics firms are constantly developing new products and new technologies, which in turn make older products obsolete. This product development gives consumers an incentive to replace their old goods with new ones. Second, because these products are relatively expensive, they have a significant impact on consumer budgets and on the economy as a whole. And third, because many resources go into the production of electronic goods—everything from plastics and metals to chemicals— the way these goods are consumed and disposed of has important economic and environmental effects. The disposal of electronic goods is a particularly critical issue. Computers and other electronic products contain various toxic materials, including lead, mercury, and other harmful substances. Every year Americans get rid of some 250 million computers. These products become e-waste, or electronic waste. Only a fraction of ewaste is recycled. When e-waste is disposed of improperly—for example, thrown into landfills—it can release toxins into the soil, air, and water. This in turn has serious consequences for the environment and human health. All electronic goods pose similar issues of consumer responsibility. One of the most useful products to examine is the cell phone, since the use of cell phones is growing rapidly, and since many consumers replace their cell phones on a regular basis.

Responsible Purchase of a Cell Phone When buying a new cell phone, a responsible consumer considers various factors, including cost, features, and quality. The phone should fit within the consumer's budget. It should contain features that the 2020 Teachers' Curriculum Institute

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consumer considers necessary. It should also be a well-made product, produced by a reliable manufacturer. If the phone is a replacement for an older phone, the consumer should consider the reasons for the replacement. Is a new phone necessary, perhaps because the old phone no longer provides adequate service? Or is the decision based on other factors, such as the desire for something new? Consumers may have various reasons for buying a new product, but the responsible consumer considers those reasons carefully. If the purchase includes a new cell phone plan, the consumer should also consider the cost of the plan and the terms of the contract. The plan should provide an adequate number of minutes at a fair market price. Also, the contract should not bind the customer to an excessively long contract period or other unreasonable terms.

Responsible Use of a Cell Phone The first rule of responsible cell phone use is to stay within the time limits of the plan. Using more than the allotted number of minutes can result in substantially higher charges. By keeping to the prearranged time limits, the consumer will stay within the budget established for cell phone use. The responsible consumer also uses a cell phone wisely and safely. A number of studies have shown, for example, that using a cell phone while driving is unsafe. Some states, such as California, have passed laws requiring the use of hands-free cell phone devices while driving. Cell phone users also should avoid giving out their phone number in online chat rooms or in other situations that could result in violations of their privacy. Phones should not be used for negative or illegal purposes, such as cyber bullying or cheating on tests. Cell phone cameras should not be used to take photographs that violate anyone else's privacy. In addition, responsible users do not talk on the phone in public places in ways that annoy other people. This generally means speaking at a low volume and keeping calls short so as not to inconvenience others. Finally, responsible consumers protect their cell phone from theft, loss, or damage to the degree possible. Accidents happen, but wise consumers make an effort to keep their cell phones safe from harm.

Responsible Disposal of a Cell Phone Cell phones present a serious disposal problem. According to the U.S. Environmental Protection Agency, Americans discard 125 million cell Level: A

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phones every year, creating 65,000 tons of waste. Like other electronic products, phones contain toxic materials that can harm the environment. Recycling cell phones keeps those toxins out of the environment and helps conserve natural resources. Yet only a small fraction of cell phones are recycled properly. Fortunately, it is relatively easy to recycle a cell phone. Various nonprofit groups run recycling programs, and many cell phone companies and electronics retail stores also accept cell phones for recycling. Some charities will take old cell phones and refurbish them for reuse in developing countries. These various options make it easier for consumers to dispose of cell phones in a responsible manner.

The Economic Impact of Obsolescence Technological change results in obsolescence. As new, more advanced products are produced, older ones become outmoded. This is an inevitable effect of technological change. But what is the economic impact of obsolescence? Obsolescence generally benefits producers, since they can sell more products. Increased sales may in turn have benefits for the economy as a whole, including increased employment. But obsolescence also results in a greater use of resources and produces more negative externalities, or side effects, in the form of e-waste. The net economic effect of these various factors is unclear. What is clear is that it is important to produce and consume as efficiently and responsibly as possible, taking negative externalities into account.

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Understanding the Effects of Globalization Economic Question: Are globalization’s effects mostly positive or negative?

Inquiry Introduction In this unit, you learned about how the United States influences global economic policies. You also learned about the costs and benefits of globalization regarding both the economies of individual countries and the collective global economy. Now, you will apply what you have learned to this Economic Inquiry.

Storyline Suppose you are a government official representing a country that is a member of the United Nations. You have been tasked with delivering a speech in front of the World Trade Organization about the impact of globalization on your country. In order to prepare your speech, you will need to research the positive and negative effects of globalization on your country. Once you have completed your research and determined the overall effects of globalization, you will make the case as to whether globalization is mostly positive or negative.

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Samsung, a South Korean electronics company, has offices in the United States. Globalization has had a variety of positive and negative social and economic effects on countries around the world.

Background As a broad economic concept, globalization is viewed positively within the context of technological and industrial advancements. When you consider globalization, you may think about the sharing and trading of knowledge, goods, and services that benefit one or more countries. Therefore, globalization can generate increased stability throughout the world. However, the effects of globalization can have unintended consequences. Suppose you are a citizen in a developing country such as China. China is known for manufacturing many goods sold in the United States and other developed countries. Many companies use Chinese labor in order to manufacture these goods at a reduced cost to the company. Although this may seem like an ideal relationship, the Chinese citizens that comprise this labor force live in extreme poverty. As a player in the global economy, China’s power is on the rise, but many citizens experience few resulting benefits as income inequality increases. Still, the middle class is growing, and many citizens can take advantage of educational and cultural exchanges as a result of globalization, such as attending college and playing professional sports. As an individual citizen, would you feel that globalization is mostly positive or negative?

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In this activity, you will take on the role of a certain country’s representative and give a speech discussing the positive and negative impacts of globalization on that country.

Inquiry Process As you consider the Economic Question, be sure to gather evidence of the effects of globalization on a variety of countries. As you formulate an opinion, consider how additional evidence may change your mind about whether globalization is mostly positive or negative. You can follow these steps and record your findings in your Interactive Student Notebook: You and your partner will be assigned a region of the world. Choose a country in your assigned region. Confirm your selection with your teacher and record your selection in your notebook. Research economic and quality-of-life indicators for your country to determine its economic status. Write a brief statement about the economic status of your country. Be sure to record your sources. Brainstorm supporting questions about the economic and social effects of globalization in your country. Research answers using 2020 Teachers' Curriculum Institute

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reliable sources. Work with your partner to create an outline of a speech that addresses how globalization economically and socially affects your country. Are these effects positive or negative? Use reasoning to make the case as to whether globalization is mostly positive or negative. As you begin to write your speech, use your outline to craft your argument. Practice your delivery by paying close attention to how you will communicate with your audience. Deliver your speech to the class. During speeches made by other representatives, take notes about the effects of globalization on other countries. After the speeches are complete, discuss the findings as a class and revisit your answer to the economic question. Based on the presentations and subsequent class discussion, do you now hold the same opinion about whether the effects of globalization are mostly positive or negative? By following these steps, you will have formulated an informed opinion about the positive and negative effects of globalization on different countries. When you are ready, get into your pairs and begin investigating the Economic Question.

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Test Your Financial Fitness This quiz was created by Rutgers University in order to assesses an individual’s financial fitness, and has been taken by hundreds of people of all ages. In 2002, the average financial fitness score was 65% and the score of people ages 12 to 24 was 56%. Use this financial fitness quiz in order to evaluate your own financial fitness. Then, determine the steps you need to take to become more financially savvy. Consider taking this quiz at the beginning of the year and the end of the year as a pre- and post-test to assess how your financial literacy has changed. You may also choose to take this quiz again every few years to see if your score improves.

Adam Smith and The Wealth of Nations Adam Smith was a Scottish economist and philosopher best known for his work, The Wealth of Nations. Published in 1776, the Wealth of Nations addresses various themes, including the division of labor, free trade and competition, and capital accumulation. Below is an excerpt from The Wealth of Nations discussing one of Smith’s most well-known ideas: the invisible hand. The invisible hand argues that an economy will function without intervention if people operate based on their own self interest. The Wealth of Nations and the invisible hand has heavily influenced the free-market approach taken by the United States in regards to the economy.

As every individual, therefore, endeavors as much as he can both to employ his capital in the support of domestic industry, and so to direct that industry that its produce may be of the greatest value; every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. . . He intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society 2020 Teachers' Curriculum Institute

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ECONOMIC RESOURCES

more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good. . . The statesman, who should attempt to direct private people in what manner they ought to employ their capitals, would not only load himself with a most unnecessary attention, but assume an authority which could safely be trusted, not only to no single person, but to no council or senate whatever, and which would nowhere be so dangerous as in the hands of a man who had folly and presumption enough to fancy himself fit to exercise it. Unreasonableness of Restraints Each nation has been made to look with an invidious eye upon the prosperity of all nations with which it trades, and to consider their gain as its own loss. Commerce, which ought naturally to be, among nations, as among individuals, a bond of union and friendship, has become the most fertile source of discord and animosity.... The violence and injustice of the rulers of mankind is an ancient evil, for which, I am afraid, the nature of human affairs can scarce admit of a remedy. But the mean rapacity, the monopolising spirit of merchants and manufacturers, who neither are, nor ought to be, the rulers of mankind, though it cannot perhaps be corrected, may very easily be prevented from disturbing the tranquility of anybody but themselves. That it was the spirit of monopoly which originally both invented and propagated this doctrine cannot be doubted; and they who first taught it were by no means such fools as they who believed it. In every country it always is and must be the interest of the great body of the people to buy whatever they want of those who sell it cheapest. The proposition is so very manifest that it seems ridiculous to take any pains to prove it; nor could it have ever been called in question had not the interested sophistry of merchants and manufacturers confounded the common sense of mankind. Their interest is, in this respect, directly opposite to that of the great body of the people. As it is the interest of the freemen of a [guild] to hinder the rest of the inhabitants from employing any workmen but themselves, so it is the interest of the merchants and manufacturers of every country to secure to themselves the monopoly of the home market. Hence in Great Britain, and in most other European countries, the extraordinary duties upon almost all goods imported by alien merchants. Hence the high duties and prohibitions upon all those foreign manufactures which can come into competition with our own. Hence, too, the extraordinary restraints upon the importation of almost all sorts of goods from those countries ... whom national animosity happens to be most violently inflamed. ... This very competition, however, is advantageous to the great body of the people, who profit greatly besides by the good market which the great expense of such a nation affords them in every other way....

Level: A

2020 Teachers' Curriculum Institute

ECONOMIC RESOURCES

Keynes vs. Hayek John Maynard Keynes and Friedrick Hayek were two prominent economist during the Great Depression best known for their contrasting economic views. Keynes is the mind behind Keynsian economics, a series of ideas established in his General Theory of Employment, Interest, and Money. Keynes’ argument circled around the idea that the output of an economy depended on demand, and that government intervention was necessary in order to reduce unemployment and increase demand. This contrasted with Hayek’s views, who argued strongly for a laissez-fair system and the dangers of a government-run economy. To this day, the debate continues as to which economy theory is more effective. The excerpt below is from Hayek's The Road to Serfdom

As every individual, therefore, endeavors as much as he can both to employ his capital in the support of domestic industry, and so to direct that industry that its produce may be of the greatest value; every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. . . He intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good. . . The statesman, who should attempt to direct private people in what manner they ought to employ their capitals, would not only load himself with a most unnecessary attention, but assume an authority which could safely be trusted, not only to no single person, but to no council or senate whatever, and which would nowhere be so dangerous as in the hands of a man who had folly and presumption enough to fancy himself fit to exercise it. Unreasonableness of Restraints Each nation has been made to look with an invidious eye upon the prosperity of all nations with which it trades, and to consider their gain as its own loss. Commerce, which ought naturally to be, among nations, as among individuals, a bond of union and friendship, has become the most fertile source of discord and animosity.... The violence and injustice of the rulers of mankind is an ancient evil, for which, I am afraid, the nature of 2020 Teachers' Curriculum Institute

Level: A

ECONOMIC RESOURCES

human affairs can scarce admit of a remedy. But the mean rapacity, the monopolising spirit of merchants and manufacturers, who neither are, nor ought to be, the rulers of mankind, though it cannot perhaps be corrected, may very easily be prevented from disturbing the tranquility of anybody but themselves. That it was the spirit of monopoly which originally both invented and propagated this doctrine cannot be doubted; and they who first taught it were by no means such fools as they who believed it. In every country it always is and must be the interest of the great body of the people to buy whatever they want of those who sell it cheapest. The proposition is so very manifest that it seems ridiculous to take any pains to prove it; nor could it have ever been called in question had not the interested sophistry of merchants and manufacturers confounded the common sense of mankind. Their interest is, in this respect, directly opposite to that of the great body of the people. As it is the interest of the freemen of a [guild] to hinder the rest of the inhabitants from employing any workmen but themselves, so it is the interest of the merchants and manufacturers of every country to secure to themselves the monopoly of the home market. Hence in Great Britain, and in most other European countries, the extraordinary duties upon almost all goods imported by alien merchants. Hence the high duties and prohibitions upon all those foreign manufactures which can come into competition with our own. Hence, too, the extraordinary restraints upon the importation of almost all sorts of goods from those countries ... whom national animosity happens to be most violently inflamed. ... This very competition, however, is advantageous to the great body of the people, who profit greatly besides by the good market which the great expense of such a nation affords them in every other way....

Level: A

2020 Teachers' Curriculum Institute